Convertible Bonds

: Pros And Cons For Companies And Investors

Dr D S Prasad
Pros and cons
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.
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.
Advantages of Debt Financing
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.
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.
What Bond Investors Should Look For?
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.
What Bond Investors Should Look For?
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.
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.
Other disadvantages
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
The 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.
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.

Why Companies Issue Convertible
Debt?
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.


Why Companies Issue Convertible
Debt?
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.
Conclusion
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.

The Difference Between Warrants &
Convertible Securities
Two common types of attractive investments are
warrants and convertible securities.
A stock warrant gives investors the right to purchase
the underlying security for a particular price.
Convertible securities give investors the ability to
convert the security into the companys common stock.
Warrants and convertibles possess many variables.
Investors deciding whether to invest in warrants or
convertibles should understand the difference in
features, advantages and disadvantages of both types
of securities before making an investment decision.

Understanding Warrants

Investors who purchase warrants inherit the right to
purchase the underlying stock or bond at a predetermined
price and time. Investors are not obligated to purchase the
underlying asset.
Unlike convertible securities, investors who trade warrants
must pay additional money to obtain the companys
common stock. The time horizon of warrants varies, but
many warrants are held for several years.
The value of a warrant is made up of two components
time and intrinsic value. The longer time left until
expiration, the greater the value of the warrant. Intrinsic
value relates to when the market share of the underlying
asset is greater than the exercise price.


Pros and Cons of Warrants

A primary advantage of investing in warrants is that
investors can potentially earn large returns with only a
small amount of money used to purchase the warrant
contract.
Warrants offer investors diversity through a variety of
underlying assets included in warrant contracts. Warrants
are liquid assets, which is beneficial if the investor chooses
to sell the contract instead of exercising the warrant.
A disadvantage of investing in warrants is that you do not
enjoy the benefits of stock ownership until you purchase
the underlying asset. A warrant is a risky investment, and
becomes worthless if the market value of the asset declines
lower than the exercise price.

Understanding Convertible Securities

A company without access to bank financing and other
traditional financing options may issue convertibles in
an effort to raise quick capital.
Convertible securities are longer-term investments
than warrants, and are usually issued as bonds or
preferred stocks that investors can convert to a
predetermined number of shares of the companys
common stock.
The number of shares given to investors is determined
by the conversion ratio. For example, a conversion of
50 to 1 means that investors can convert one bond
with a $1,000 face value to 50 shares of common stock


Pros and Cons of Convertibles

The combination of bond and stock attributes makes convertible
securities beneficial for investors.
An advantage of investing in convertible securities is if the
companys stock price is undervalued, you can earn a significant
rate of return. Investors benefit from convertible bonds because the
bond pays a fixed rate of interest until it is converted. This is
especially beneficial if the company does not pay a dividend.
A disadvantage of investing in convertible securities for some
investors is the need to understand the bond and equity markets.
Convertible bonds are tied to the issuing companys credit rating
and typically pay less interest than regular corporate bonds. A
disadvantage of investing in convertible bonds is that companies
with poor credit ratings have a greater risk of defaulting.

Conversion Premium
The amount by which the price of a convertible security
exceeds the current market value of the common stock into
which it may be converted.
A conversion premium is expressed as a dollar amount and
represents the difference between the price of the
convertible and the greater of the conversion or straight-
bond value.
Convertibles are securities, such as bonds and preferred
shares, that can be exchanged for a specified number of
another form (typically common stock) at an agreed-upon
price.
Convertibles can be converted at the will of the investor or
the issuing company can force the conversion.

Conversion Premium

The equity value of a convertible bond was determined to be its conversion value.
Conversion premium can be calculated easily by simply taking the difference
between the current market price of the convertible and the conversion value and
expressing it as a percentage.
Since the convertible bond is more secure than common stock and generally pays
higher interest than the stock dividend, the convertible bond buyer is willing to
pay a premium over conversion value.
Market forces determine the amount of premium that a particular convertible may
command in the marketplace.
However, it should make sense that, as a convertible bond price increases above
its investment value, its fixed income attributes give way to equity characteristics,
decreasing the conversion premium. On the other hand, if the stock price declines,
the convertible bond price approaches its fixed income value and the conversion
premium increases.
Convertible bonds that are trading near their fixed income values with substantial
conversion premiums are called "busted converts." Their equity component is of
little value, and they trade mainly on their fixed income characteristics.

Figure(next slide) depicts a typical convertible
price curve, with the shaded area denoting
conversion premium.
Notice that as the stock increases in value,
conversion premium gradually decreases until it
becomes zero.
At that point, the convertible market price and
conversion value are equal.
As the common stock declines in value, the
convertible gains conversion premium because it
is approaching its investment value.
Conversion premium

Convertible Bonds: An Example

To help clarify some of these concepts, we
present a hypothetical example in the table
below and graphically.
Assume that a new issue convertible has come
to market. It has a 5 percent coupon and 10
years to maturity. The issuing company has
other 10 year debt that carries an 8 percent
yield, and the company's stock is currently
trading at $42.


Convertible Bonds: An Example

XYZ Company

Convertible Bond

Coupon
5%
Maturity
10 years
Straight bond yield to maturity
8%
Conversion price
$50/share
Current stock price
$42/share
Conversion ratio
20 shares per bond


Convertible Bond

Conversion premium & Investment
Premium
The bond indenture specifies a conversion price of $50. Since we
know that the conversion price is the effective price for conversion
into stock with the bond at par, we divide the par value of the bond
($1,000) by $50, resulting in a conversion ratio of 20 shares.
To calculate the current conversion value, we know that the stock
price is currently $42. Multiplying $42 by 20 shares, we get a
current conversion value of $840. If the issue is sold at par, then
the conversion premium would be 19 percent ([$1,000 - 840]/840).
The investment value of the convertible at issuance would be the
security with the 5 percent coupon discounted at a yield to maturity
of 8 percent. The result, according to standard bond calculations, is
79.87, or a dollar value of $798.70.
The investment premium would be 25.20 percent ([$1,000 -
798]/798).


A Convertible's Investment Value
Investment Value Calculation
=50 Annuity factor(8%,10years)+1000
PVIF(8%,10 years) =50(6.710)+1000(0.463)
= 335.50+463.00=798.50

Investment Premium

The convertible bond's investment premium is the
difference between the convertible's market price and
its investment value, expressed as a percentage.
An important measure of the basic value of the
convertible is its premium over investment value.
This value is important because it indicates the level of
downside risk and can be monitored as market prices
change. For example, in the case of a bond with a par
value of $1,000 and an investment value of $798.70,
the investment premium is ([1,000 - 798.70]/ 798.70),
or 25.2 percent.


The higher the investment premium, the more
sensitive the market price of the convertible is to a
decline in the underlying common stock.
A high market price relative to investment value is
caused by increases in the value of the underlying
stock such that the convertible's market value depends
on the value of the stock.
There is less downside protection because the stock
would have to decrease in value by a significant
amount before the market price of the convertible
would approach the investment value and offer
protection.

Similarly, when the investment premium is small,
a small decrease in the value of the underlying
stock would result in the market price reaching
the investment value.
At that time, the investment value floor serves as
significant downside protection.
Furthermore, when the investment premium is
small, the convertible is more interest rate
sensitive rather than equity sensitive and will
typically be vulnerable to changes in market
interest rates.


Basic convertible bonds calculations

stock price $30.00 per share
stock dividend $0.50 per share
convertible market price $1,000
coupon rate 7.00%
maturity 20 years
conversion price $36.37
Stock dividend yield = annual dividend rate/
current stock price= $0.50 / $30.00 = 1.67%

Conversion ratio
= number of shares for which one bond may be
exchanged
= par / conversion price
= $1,000 / $36.37 = 27.50 shares
Conversion value
= equity value or stock value of the convertible
= stock price x conversion ratio
= $30.00 x 27.50 = $825.00

Premium for call right

An investor who purchases a convertible bond
rather than the underlying stock typically pays a
premium over the current market price of the
stock.
Why would someone be willing to pay a
premium to buy this stock?
The market conversion premium per share is
related to the price of a call option limit the
downside risk of the convertible bond.
Conversion Premium Calculation
Conversion premium = (convertible price
conversion value) / conversion value
= ($1,000 $825.00) / $825.00 = 21.21%
Conversion premium
In a bullish environment, the enthusiasm of the market
boosts conversion premium levels.
National Semiconductor Corporation (Sept 1995)
coupon rate 6.5 percent and conversion premium of
45 percent.
3Com Corporation (Nov., 1994) coupon rate
10.25 percent and conversion premium of 70
percent.
Bondholders are compensated with a high
coupon rate while they wait for the stock price to
rise.

Factors that affect the bond
component

Interest rates
Credit rating/spreads
Coupon
Duration

Factors that affect the warrant
component

Stock performance
Embedded strike price
Common dividend yield and dividend
growth rate
Stock volatility
Life of warrant / call protection
Floor value
The floor value of a convertible bond is the greater of
1. Conversion value
2. Bond investment value value as a corporate bond
without the conversion option (based on the convertible
bonds cash flow if not converted).
To estimate the bond investment value, one has to
determine the required yield on a non-convertible bond
with the same quality rating and similar investment
characteristics.
If the convertible bond does not sell for the greater of
these two values, arbitrage profits could be realized.

Bond investment value

Present value of the interest and principal payments discounted at
the straight (non-convertible) bond interest rate
bond interest value =
where P = par value, r = discount rate, C = coupon rate,
n = number of periods to maturity.
take r = 10%
present present
value value
Years payment factor
1 - 20 $80 8.514 $681.12
20 $1,000 0.149 $149.00
$830.12

Estimation of the discount rate

Use the yield-to-maturity of a similar
nonconvertible bond as a proxy.
Ratings are not very responsive to changing
financial fundamentals.
The apparent deterioration of the
creditworthiness of an issue will not be
reflected in the convertible price because the
common stock may be rising due to higher
share price volatility.