AFIC convertible notes are offering an interesting opportunity...

AFIC convertible notes are offering an interesting opportunity at the moment. You are almost fully protected to the downside, but will participate in any upside to AFI’s share price… Indeed if the AFI share price remains unchanged, you can still generate a reasonable return. I’ll explain below.

The downside: At today’s price of $110, the worst you can receive between now and February 2017 is approximately $109.38. That is, you’ll receive the 3 coupon payments remaining plus the face value of the notes, $100 (this assumes the AFI share price in Feb-17 is less than 5.0864, in which case you would opt to receive the face value on 28 February 2017 of $100). Granted, this is not a great outcome, however, losing less than 1% of your capital in the event the share market flounders between now and February 2017 is not a bad outcome given the potential upside discussed below.

The upside:
If the AFI share price is greater than $5.0864 on 28 February 2017, you would obviously exercise the option to receive 19.66 AFI shares per note. Based on the following AFI share prices I get the following nominal returns:

At an AFI share price of:
$5.25: 3 coupon payments totalling $9.38 + 19.66 shares at $5.25 each = $112.59 (2.4% return)
$5.50: $9.38 + 19.66 shares at $5.50 each = $117.51 (6.8% return)
$5.75: $9.38 + 19.66 shares at $5.75 each = $122.42 (11.3% return)
$6.00: $9.38 + 19.66 shares at $6.00 each = $127.34 (15.8% return)
$6.25: $9.38 + 19.66 shares at $6.50 each = $132.25 (20.2% return)
$6.50: $9.38 + 19.66 shares at $6.75 each = $137.17 (24.7% return)

Now, I recognise these are the total return over the next 15 months, so on an annualised basis they are a little lower. However, even based on today’s AFI share price of $5.79 the return is 12.0%, on an annualised basis, it is 9.4%, which given you have such little downside risk, I think is a reasonable proposition. Remember that assumes AFI share price does not appreciate at all.

Feel free to google the prospectus for the transaction and you can read up on the terms. The terms actually allow you to convert at each interest payment date. Assuming the AFI share price is unchanged at the next coupon date on 28 February 2016 you could opt to convert then and receive the interest coupon of approx. $3.12 plus 19.66 shares at $5.79, which adds up to $116.95. If you bought at $110 today, that’s not a bad return for just over 3 months…

Valuation:
Based on a bottom up valuation, I believe the security should be priced at around $116 being, the face value ($100) plus accrued interest ($1.44) plus bond premium (circa $1.00) + option value (circa $14).

IMO, at their current price, the AFIC notes are a far better proposition than AFI shares due to the undervaluation of the notes as well as the downside protection. The credit risk of notes is very small given the large ASX listed portfolio of shares that AFI holds and their low overall gearing.

My disclosure: I own the notes, I don't own AFI shares. My sentiment is buy the notes, hold the shares.

Please do your own research. The above analysis is my analysis, so feel free to question it if you think I'm missing something.