Wednesday, April 17, 2013

Convertible Bonds

Convertible Bonds

What Does Convertible Bond Mean?
A bond that can be converted into a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder.

Convertibles are sometimes called "CVs".

Investopedia explains Convertible Bond
ssuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity anyway should the company continue to do well.

From the investor's perspective, a convertible bond has a value-added component built into it; it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock.

New players to the investing game often ask what convertible bonds are, and whether they are bonds or stocks. Essentially, they are corporate bonds that can be converted by the holder into the common stock of the issuing company. In this article, we'll cover the basics of these chameleon-like securities as well as their upsides and downsides.

What Is a Convertible Bond?
As the name implies, convertible bonds, or converts, give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and thus benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly there is no conversion and an investor is stuck with the bond’s sub-par return (below what a non-convertible corporate bond would get). As always, there is a tradeoff between risk and return. (For more insight, read Get Acquainted With The Bond Price-Yield Duo.)

Conversion Ratio
The conversion ratio (also called the conversion premium) determines how many shares can be converted from each bond. This can be expressed as a ratio or as the conversion price, and is specified in the indenture along with other provisions.


A conversion ratio of 45:1 means one bond (with a $1,000 par value) can be exchanged for 45 shares of stock. Or it could be specified at a 50% premium, meaning that if the investor chooses to convert the shares, he or she will have to pay the price of the common stock at the time of issuance plus 50%. Basically, these are the same thing said two different ways.

This chart shows the performance of a convertible bond as the stock price rises. Notice that the price of the bond begins to rise as the stock price approaches the conversion price. At this point your convertible performs similarly to a
stock option. As the stock price moves up or becomes extremely volatile, so does your bond.

It is important to remember that convertible bonds closely follow the underlying's price. The exception occurs when the share price goes down substantially. In this case, at the time of the bond's
maturity, bond holders would receive no less than the par value.

Forced Conversion
One downside of convertible bonds is that the issuing company has the right to call the bonds.  In other words, the company has the right to forcibly convert them. Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed, or this may occur at the bond's call date. This attribute caps the capital appreciation potential of a convertible bond. The sky is not the limit with converts as it is with common stock. (To learn more about callable bonds, read Bond Call Features: Don't Get Caught Off Guard.)

The Numbers
As we mentioned earlier, convertible bonds are rather complex securities for a few reasons. First, they have the characteristics of both bonds and stocks, confusing investors right off the bat. Then you have to weigh in the factors affecting the price of these securities; these factors are a mixture of what is happening in the interest-rate climate (which affects bond pricing) and the market for the underlying stock (which affects the price of the stock).

Then there’s the fact that these bonds can be called by the issuer at a certain price that insulates the issuer from any dramatic spike in share price. All of these factors are important when pricing convertibles.


Suppose that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25%
premium. This means that TSJ will have to pay $500,000 in interest annually, or a total $1.5 million over the life of the converts.

If TSJ’s stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds for shares at a price of $50 ($40 x 1.25 = $50). Therefore if the stock was trading at say $55 by the bond's 
expiration date, that $5 difference per share is profit for the investor. However there is usually a cap on the amount the stock can appreciate through the issuer’s callable provision.

For instance, TSJ executives won’t allow the share price to surge to $100 without calling their bonds - and capping investors' profits. Alternatively, if the stock price tanks to $25 the convert holders would still be paid the 
face value of the $1,000 bond at maturity. This means that while convertible bonds limit risk if the stock price plummets, they also limit exposure to upside price movement if the common stock soars.

Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex then they really are. At their most basic, convertibles provide a sort of security blanket for investors wishing to participate in the growth of a particular company they’re unsure of. By investing in converts you are limiting your downside risk at the expense of limiting your upside potential.

What is the difference between convertible and reverse convertible bonds?

The difference between a regular convertible bond and a reverse convertible bond is the options attached to the bond. While a convertible bond gives the bondholder the right to convert the asset to equity, a reverse convertible bond gives the issuer the right to convert to equity.

To review, convertible bonds give bondholders the right to convert their bonds into another form of debt or equity at a later date, at a predetermined price and for a set number of shares. Convertible bondholders are not obligated to convert their bonds to equity, but they may do so if they choose. The conversion feature is analogous to a 
call option that has been attached to the bond. If the equity or debt underlying the conversion feature increases in market price, convertible bonds tend to trade at a premium. If the underlying debt or equity decreases in price, the conversion feature will lose value. But even if the convertible option comes to be of little value, the convertible holder still holds a bond that will typically pay coupons and the face value at maturity. The yield on this type of bond is lower than a similar bond without the convertible option because this option gives the bondholder additional upside.

Reverse convertible bonds are a similar vehicle to convertible bonds as both contain embedded
derivatives. In the case of reverse convertible bonds, the embedded option  is a put option that is held by the bond's issuer on a company's shares. These investments give the issuer the right, but not the obligation, to convert the bond's principal into shares of equity at a set date. This option is exercised if the shares underlying the option have fallen below a set price, in which case the bondholders will receive the equity rather than the principal and any additional coupons. The yield on this type of bond is higher than a similar bond without the reverse option.

An example of a reverse convertible bond is a bond issued by a bank on the bank's own debt with a built-in put option on the shares of, say, a blue chip company. The bond may have a stated yield of 10-20%, but if the shares in the blue chip company decrease substantially in value, the bank holds the right to issue the blue chip shares to the bondholder, instead of paying cash at the bond's maturity.

There are pros and cons to the use of convertible bonds as a means of financing by corporations. One of several advantages of this delayed method of equity financing is a delayed dilution of common stock and earnings per share (EPS). Another is that the company is able to offer the bond at a lower coupon rate - less than it would have to pay on a straight bond. The rule usually is that the more valuable the conversion feature, the lower the yield that must be offered to sell the issue; the conversion feature is a sweetener. Read on to find out how corporations take advantage of convertible bonds and what this means for the investors who buy them. (For background reading, see Convertible Bonds: An Introduction.)

Advanced Bond Concepts

Advantages of Debt Financing
Regardless of how profitable the company is, convertible bondholders receive only a fixed, limited income until conversion. This is an advantage for the company because more of the operating income is available for the common stockholders. The company only has to share operating income with the newly converted shareholders if it does well. Typically, bondholders are not entitled to vote for directors; voting control is in the hands of the common stockholders.

Thus, when a company is considering alternative means of financing, if the existing management group is concerned about losing voting control of the business, then selling convertible bonds will provide an advantage, although perhaps only temporarily, over financing with common stock. In addition, bond interest is a deductible expense for the issuing company, so for a company in the 30% tax bracket, the federal government in effect pays 30% of the interest charges on debt. Thus, bonds have advantages over common and
preferred stock to a corporation planning to raise new capital. (To learn more, read What do people mean when they say that debt is a relatively cheaper form of finance than equity?

What Bond Investors Should Look For
Companies with poor credit ratings often issue convertibles in order to lower the
yield necessary to sell their debt securities. The investor should be aware that some financially weak companies will issue convertibles just to reduce their costs of financing, with no intention of the issue ever being converted. As a general rule, the stronger the company, the lower the preferred yield relative to its bond yield.

There are also corporations with weak 
credit ratings that also have great potential for growth. Such companies will be able to sell convertible debt issues at a near-normal cost, not because of the quality of the bond but because of the attractiveness of the conversion feature for this "growth" stock. When money is tight and stock prices are growing, even very credit-worthy companies will issue convertible securities in an effort to reduce their cost of obtaining scarce capital. Most issuers hope that if the price of their stocks rise, the bonds will be converted to common stock at a price that is higher than the current common stock price. By this logic, the convertible bond allows the issuer to sell common stock indirectly at a price higher than the current price. From the buyer's perspective, the convertible bond is attractive because it offers the opportunity to obtain the potentially large return associated with stocks, but with the safety of a bond. (Learn more about investing in corporate bonds in Corporate Bonds: An Introduction To Credit Risk.)

The Disadvantages of Convertible Bonds
There are some disadvantages for convertible bond issuers, too. One is that financing with convertible securities runs the risk of diluting not only the EPS of the company's common stock, but also the control of the company. If a large part of the issue is purchased by one buyer, typically an
investment banker or insurance company, conversion may shift the voting control of the company away from its original owners and toward the converters. This potential is not a significant problem for large companies with millions of stockholders, but it is a very real consideration for smaller companies, or those that have just gone public. (For related reading, see Corporate Takeover Defense: A Shareholder's Perspective.)

Many of the other disadvantages are similar to the disadvantages of using straight debt in general. To the corporation, convertible bonds entail significantly more risk of
bank­ruptcy than preferred or common stocks. Furthermore, the shorter the maturity, the greater the risk. Finally, note that the use of fixed-income securities magnifies losses to the common stockholders whenever sales and earnings decline; this is the unfavorable aspect of financial leverage.

indenture provisions (restrictive covenants) on a convertible bond are generally much more stringent than they are either in a short-term credit agreement or for common or preferred stock. Hence, the company may be subject to much more disturbing and crip­pling restrictions under a long-term debt arrangement than would be the case if it had borrowed on a short-term basis, or if it had issued common or preferred stock.

Finally, heavy use of debt will adversely affect a company's ability to finance operations in times of economic stress. As a company's fortunes deteriorate, it will experience great difficulties in raising capital. Furthermore, in such times investors are increasingly concerned with the security of their investments, and they may refuse to advance funds to the company except on the basis of well­-secured loans. A company that finances with convertible debt during good times to the point where its debt/assets ratio is at the upper limits for its industry simply may not be able to get financing at all during times of stress. Thus, corporate treasurers like to maintain some "reserve borrowing capacity". This restrains their use of debt financing during normal times. (For more on corporate debt, see 
Evaluating A Company's Capital Structure and Debt Reckoning.)

Why Companies Issue Convertible Debt
The decision to issue new equity, convertible and fixed-income securities to raise
capital funds is governed by a number of factors. One is the availability of internally generated funds relative to total financing needs. Such availability, in turn, is a function of a company's profitability and dividend policy.

Another key factor is the current market price of the company's stock, which determines the cost of equity financing. Further, the cost of alternative external sources of funds (i.e., interest rates) is of critical importance. The cost of borrowed funds, relative to equity funds, is significantly lowered by the deductibility of interest payments (but not of dividends) for federal income tax purposes.

In addition, different investors have different risk-return tradeoff preferences. In order to appeal to the broadest possible market, corporations must offer securities that interest as many different investors as possible. Also, different types of securities are most appropriate at different points in time.

Used wisely, a policy of selling differentiated securities (including convertible bonds) to take advantage of market conditions can lower a company's overall cost of capital below what it would be if it issued only one class of debt and common stock. However, there are pros and cons to the use of convertible bonds for financing; investors should consider what the issue means from a corporate standpoint before buying in.

Can private corporations issue convertible bonds?
The first step to answering this question requires defining the term "private corporation". Many times, the term "private corporation" refers to a privately held company that is either a sole proprietorship (one owner) or a partnership (multiple owners). Other times, it refers to a business that's actually incorporated under state laws, but not traded on any exchange or by over-the-counter market makers.

In the instance of a truly private company that is owned by one or multiple people, 
convertible bonds cannot be issued. The reason has less to do with any laws against privately held companies issuing bonds and more to do with the fact that no shares of stock exist into which to convert the bonds.

On the other hand, a closely-held subchapter S or C corporation, which does not trade on any exchange, theoretically may issue convertible bonds if allowed by its corporate charter and state laws. The feasibility of executing a bonds issue of this kind is another matter, however, because many closely held corporations might have only 100 shares of stock outstanding, if not less. It is not unheard of for an owner or local investor to lend smaller corporations money in the form of bonds that come with a convertible feature. However, this usually is carried out as a means of protecting the lender by permitting ownership in the company if it fails to repay the loan.

No comments: