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.
Keep it up!! You have done the nice job having provided the latest information.
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A bond is a negotiable debt security under which the issuer borrows a given amount of money, called the principal amount. In exchange, the borrower agrees to pay fixed amounts of interests, also called the coupons, during a specific period of time. guarantor loans
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