CONVERTIBLE BONDS A convertible bond (‘CB’) is simply a corporate bond that has the added feature of being convertible into a fixed number of shares of the issuer. Conversion terms and conditions are defined by the issuer at the time of issuance. Apart from the equity option, convertible bonds usually have embedded in them (issuer) calls and/or (holder) puts. The bonds can be converted into equity at a pre-specified ratio, the conversion ratio; or alternatively at a pre-specified price, the conversion price, which is normally at a premium to the underlying equity spot price at the time of issuance. Convertibles have the characteristics of both bonds and equities, i.e. they are hybrids. Convertibles typically have a lower coupon and yield compared with a straight bond due to the embedded option value. There are many options available to issuers when structuring a convertible bond to suit their financing needs best, including: ◆ “Plain vanilla” convertible bonds, e.g. a 5-year convertible bond with a 2% coupon and 20% conversion premium with a call option after two years and a put option after three years. A call gives the issuer the opportunity to redeem the bond, whereas a put allows the bondholder to do the same. Usually holders of convertible bonds can convert at any time after the conversion date, but sometimes the issuer can force early conversion. Either way, on conversion the common shareholders are diluted. This is why the issuer will sometimes have a call option to buy back the convertible bond before conversion. ◆ Exchangeable bonds – this gives the holder the option to exchange the bond for the underlying stock of a company other than the issuer, e.g. shares in the issuer’s subsidiary, associate or trade investment. Companies often use exchangeable bonds to divest of their positions in other companies. The important advantage for issuers is that the exchangeable bonds do not dilute the issuer’s shareholders. As with exchangeable bonds, holders of convertible bonds generally do not have the voting privileges enjoyed by holders of the common stock. 1 CONVERTIBLE BONDS Regulators generally classify convertible bonds as equity rather than debt. This classification is helpful to issuers as the interest payments become tax breaks and this class of securities does not increase an issuer’s debt gearing, or debt-to-equity ratio. Convertible bonds trade like other stocks, but the conversion premium influences their trading prices. The lower the conversion premium, i.e. the closer the bonds are to being “in the money”, the more closely the bonds will track the price of the common stock. Convertible bonds are usually issued offering a higher yield than that obtainable on the underlying shares into which the bonds convert. They are safer than preferred or common shares for the investor. They provide asset protection, because the value of the convertible bond can only fall to the value of the bond floor. At the same time, convertible bonds can provide the possibility of high equity-like returns. Also, convertible bonds are usually less volatile than regular shares. 0 Beware Toxic Convertible Bonds However, be warned that there are some financial institutions that are hawking what can best be termed as “toxic” convertibles to small and unsophisticated companies here in Singapore, despite the reputational risk such unethical behaviour carries. The simultaneous purchase of convertible bonds and the short sale of the same issuer's common stock is a hedge fund strategy known as convertible arbitrage. The motivation for such a strategy is that the equity option embedded in a convertible bond is a source of cheap volatility, which can be exploited by convertible arbitrageurs. In limited circumstances, certain convertible bonds can be sold short, thus depressing the market value for a stock, and allowing the debt-holder to claim more stock with which to sell short. This is known as death spiral financing. 1 What is meant by death spiral financing? This is a process where convertible financing used to fund mostly small cap companies can be used against it in the market place to cause the company’s stock to fall dramatically and can lead to the company’s ultimate downfall. 2 CONVERTIBLE BONDS Many small companies rely on selling convertible debt to large private investors to fund their operations and growth. This convertible debt, often convertible preferred stock or convertible debentures, can be converted to the common stock of the issuing company usually at steep discounts to the of the common stock. Under the typical “death spiral” scenario the holder of the convertible debt initially the issuer’s common stock which often causes the stock price to decline at which time the debt holder converts some of the convertible debt to common shares with which he then covers his short position. The debt holder continues to sell short and cover with converted stock which along with selling by other shareholders, alarmed by the falling price, continually undermines the share price making the shares unattractive to new investors. This can severely limit the company’s ability to obtain new financing if the need arises. An important characteristic of this kind of convertible debt is that it often carries conditions like a quarterly or semi-annual reset of the conversion price to keep the conversion price more or less close to the actual stock price. But a lower conversion price also increases the number of shares that a bond holder gets in exchange for one bond, increasing the dilution of existing shareholders. A lower price reset can also force investors that have set up a long CB/short stock position to sell more stock ("adjust the delta"), creating a vicious circle, hence the nickname death spiral. ❉ Advantages to issuers of Convertible Bonds? Lower fixed-rate borrowing costs. Convertible bonds allow issuers to issue debt at a relatively low cost. Typically, a convertible bond at issue may yield 2%, less than the interest on straight debt, or dividend on the underlying equity. Locking into low fixed–rate long-term borrowing. Issuers can swap variable rate bank borrowings for lower coupon fixed rate convertible borrowing. Higher conversion price than a rights issue strike price. The conversion price of a convertible bond is usually fixed at a significant premium to the then prevailing market price. Admittedly there is equity dilution on conversion but not as great as with a rights issue when the shares are offered at a discount to the market. Voting dilution deferred. With a convertible bond, dilution of the voting rights of existing shareholders only happens on eventual conversion of the bond. 3 CONVERTIBLE BONDS Increasing debt gearing. A company will not increase straight debt beyond certain limits, without it negatively impacting upon its credit rating and cost of debt. Convertibles can provide additional funding when the straight debt “window” may not be open. Takeover paper. Convertibles can be used as a currency in takeovers. The bidder can offer a higher income on a convertible than the dividend yield on the target company’s shares, without having to lift the dividend yield on the bidder’s own shares. This eases the process for a bidder with low-yielding shares acquiring a company with higher-yielding shares. Perversely, the lower the yield on the bidder’s shares, the easier it is for the bidder to create a higher conversion premium on the convertible, with consequent benefits for the mathematics of the takeover. There are several cosmetic attractions. The pro-forma fully-diluted earnings per share shows none of the extra cost of servicing the convertible up to the conversion day irrespective if the coupon was 1% or 10%. The fully diluted earnings per share is also calculated on a smaller number of shares than if equity was used as the takeover currency. In some jurisdictions convertibles of various structures may be treated as equity by the local accounting profession. In such circumstances, the accounting treatment may result in less pro-forma debt than if straight debt was used as takeover currency or to fund an acquisition. The perception is that gearing is less with a convertible than if straight debt is used instead. ◆ What Next? ACH works closely with a AAA-rated European bank that is looking to fund convertible bond issues from companies not only in Singapore but elsewhere in the region including Australia, India, Malaysia and Thailand. The European bank is the principal and holds all or most of the CB’s on its own books. It does not syndicate it out or sell it off to other financial institutions. This ensures that you know who the CB shareholder is, thus eliminating any risk of unidentified parties buying into the bonds in the secondary market. 4 CONVERTIBLE BONDS By dealing with just one party this ensures a high likelihood that the transaction will be successful. This also obviates the need for marketing the issue and road shows. Moreover, you only need to deal with enquiries from one institution rather than answering to a plethora of individual bondholders. Finally, the backing and support of a AAA-rated bank will reflect positively on your company’s credit rating and standing in the market. If your company is considering raising capital we, at ACH, would be very happy to discuss this in more detail with you. 5