Monday, July 1, 2013

Convertible Bonds: Free Lunch or Expensive Banquet?

Convertible bonds are a hybrid instrument. Their combined return is based on a coupon plus an option to convert the bond into the firm’s equity at a set price. They are similar to straight debt with non detachable warrants. Convertible bond issuance peaked in 2007 at around $100B.Issuance bottomed out at $20B last year. Concerns over rising rates, both treasury and credit spread increases, following recent Federal Reserve QE statements have sparked renewed interest in convertibles. The selling point for issuers is they can cushion the impact of rising rates. Issuers should, however, beware of investment bankers using less than transparent option features to disguise the true costs of convertibles.

The first alleged convertible benefit is the offer of cheap debt compared to a straight debt instrument for the same firm. The difference is frequently 2% or more. It is only cheap if you ignore the option value of the conversion right into common shares. Unless investors are stupid, and they are not, they are willing to accept a lower coupon only because they believe the conversion feature is valuable. 

The second alleged benefit is the ability to sell expensive equity. The conversion price is usually set at a premium of 20-25% to the current share price. Thus, it is claimed you are effectively issuing shares at a premium to the current price. Obviously, this cannot be true otherwise there would be no IPOs - everyone would use convertibles as a backdoor IPO. What is missing in the analysis is that when the conversion occurs, the firm will be issuing shares at a discount to the then current market price. Conversion occurs when the issuer’s prospects are bright and when it could best use debt interest rate tax shields. Conversely, the convertible remains debt when the issuer’s prospect dim -  just when it could use the flexibility benefits of equity.

As you can probably tell, I am not a fan of convertibles given the potential for investment bankers overselling them. I would prefer, for most issuers, a straight debt or equity issue.  Nonetheless, there are certain firms for whom convertibles make sense. They are primarily smaller, lower credit quality and faster growing firms. Such firms have a difficult time accessing financial markets given their uncertain prospects. Convertibles give investors upside opportunities (the equity conversion kicker) with downside protection (the debt component). Hence, they are frequently used in start-ups and venture financings. Larger, mature and more creditworthy firms, however, should not issue convertibles-absent some unmet investor demand that offers a bargain deal.

The announcement impact of a convertible issuance on a public firms stock price is usually negative (usually 2 %+). This is similar to what happens with an equity issuance announcement. Convertibles can be valued using an option pricing approach. In practice, a breakeven years (BE) approach is often used for pricing purposes. It compares the conversion premium (Prem) to the coupon (C) less the issuer’s dividend yield (DY) as follows: BE=Prem /(C-DY).The usual range BE range is between 2-4 years. Shorter BEs are attractive to investors whereas, issuers favor longer BEs. The size of the Prem investors are willing to accept depends on the extent to which the convertible offers higher current income (C) than an investment in the underlying common (DY) would.

 For example, assume the issuer’s current stock price is $8, and the bond offers the right to convert into 100 shares. This represents a conversion price of $10 ($1000 par/100 shares conversion right). Thus, the conversion premium is 25% (($10-$8)/$8).If the issuer’s dividend yield is 2% and the bond coupon is 7%, then the BE is 5 years [25% Prem/ (7% coupon-2% dividend)]. This is slightly more favorable to the issuer, but may still be acceptable to investors depending on market conditions.

 Changing Federal Reserve QE policy will impact financing decisions. It is important to carefully think thru the options to avoid being sold investment banker snake oil. For most firms it is best to keep it simple. If you need equity - raise it now and ignore the dilution. You can consider repurchasing shares later. If need debt and have the cash flow to cover the debt service requirement, then issue the debt even at a higher than planned coupon with a subsequent equity refunding as an option.

J


p.s. As a “reformed” investment banker I have a limited pass to poke at them now and again. I may have exceeded that pass in this post.

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