As a courtesy for those who may not have prior experience with convertible bonds, we provide some background information on some general questions.
What are convertible offerings?
Convertible offerings are sales of securities convertible into equity (generally common stock) of public companies. For example, when the convertible security is a bond, convertible bonds can be converted into company shares according to a conversion ratio that is generally determined at the time of issuing the bond (typically based on a premium to the current share price at the time of the offering). Interest offered by convertible bonds is typically lower than that of traditional debt instruments given the potential value investors receive through the right to conversion if the value of the company’s stock price increases.
What is convertible debt?
Convertibles come in many flavors, and can be structured as debt-like or equity-like instruments. The convertible debt structure is the most common. In a convertible debt instrument investors lend the money to the issuing company in exchange for coupon payments (though the stated interest rate can be 0% in low-interest rate periods) and the option to receive additional value by converting this debt into company shares if certain conditions are met or at maturity. If the stock price at maturity is below the conversion price, the investors will generally elect to receive their original principal back. Typical convertible debt maturity is five to seven years.
What is a cash convertible?
Depending on the settlement method, convertibles can be converted into company shares, cash, or combination of cash and company shares. Settlement method choice generally sits with the company who issues the convertible. A cash convertible is a convertible that only permits cash settlement upon conversion. When a convertible is cash settled and stock is above conversion price, rather than paying back the face amount of the convertible, the amount paid out is the cash value of the securities the convertible references.
Are convertible securities a good investment? Why are convertible bonds attractive to investors?
Convertible securities combine the advantage of both debt and equity instruments since they offer fixed interest, principal repayment, and the potential equity gains if the stock value of the company appreciates. Unlike equity offerings, convertibles offer investors a bond floor (i.e. less downside risk) while allowing participation on the equity upside.
What kind of investors are best suited to invest in convertible securities?
Hedge funds and fundamental long-only (i.e., non-hedge) accounts are the primary players in the convertible market. Hedge funds often purchase convertible securities to monetize volatility by hedging their exposure to the equity portion of the convertible. Fundamental investors purchase convertible securities to benefit from stock price increases in the future.
How do I value my convertible notes?
Investors generally perceive convertible bonds as being worth the sum of (1) the value of a (discount) bond with a coupon below the issuer’s cost of borrowing in the credit market, and (2) an equity call option struck at the conversion price. The value of a bond is calculated by finding the present value of cash flows, while the equity call option value is determined using Black-Scholes valuation. There are additional technical adjustments that should be considered. Matthews South has developed proprietary software for modeling and monitoring of new issues or existing positions. Please get in touch to discuss the details of your situation.
How is a convertible bond priced?
When a convertible bond is offered to the market, the primary variables that are determined in the marketing process are coupon, which is paid semi-annually, and conversion premium. Conversion premium is a percentage (typically between 20% and 50%) above then-current stock price (stock price close or VWAP on the day of marketing) which is used to then set the conversion price and determines the point of future dilution.
Who can issue convertible bonds or convertible notes?
Convertible bonds (also known as convertible notes) can be issued by any public or private company. Convertibles are most frequently issued by high-growth, non-rated companies. Companies with ratings also access the convertible market, including investment grade rated issuers. The two most historically active sectors are technology and healthcare.
Why do companies issue convertible bonds?
Companies often consider convertible debt or convertible bonds as a method to raise funds with a lower coupon cost vs. what would be achievable in the straight debt markets. In contrast to straight debt markets, convertibles do not include covenants and as such offer more flexibility. Additionally, convertibles are less dilutive vs. a common stock offering as any shares issued are typically sold at a premium to stock price at issue. Convertible bonds also offer structural enhancements to further reduce potential for dilution.
Do convertible bonds have a maturity date?
Yes, convertible bonds have a maturity date. Public convertibles (debt which converts into publicly listed shares) typically have a maturity of five to seven years. Upon maturity, investors are paid the value of their investment or can choose to convert the bonds and receive company shares, cash, or combination of cash and shares, as dictated by the convertible settlement method.
What happens to convertible notes if a company fails?
As with any equity or debt instrument, if the company goes bankrupt, the security’s value is dependent on its claim in bankruptcy. The claim for convertible notes or convertible debt depends on the seniority of the debt component. Convertible debt is typically structured as senior unsecured debt that gives investors a senior claim on the company’s assets compared to equity, but junior to any secured debt.
Can private companies issue convertible notes?
Private companies can issue convertibles, but only in the private markets. These securities are often executed with a select number of investors, and tend to have more onerous terms vs. their public market alternatives.
What happens to convertible bonds when interest rates rise?
Convertible bonds pay fixed coupon payments on a semi-annual basis. Similarly to other instruments that have fixed interest, in case of an increase in interest rates, the value of the bond declines. Unlike straight bonds, convertible bonds tend to be less impacted given the equity option component of the convertible instrument. Issuing a convertible bond also becomes more expensive in a higher interest rate environment, but tends to be less expensive vs. straight bond market alternatives.
What happens to convertible debt in an acquisition?
Convertible bonds that are outstanding at the time of the acquisition of the issuer are contractually adjusted.
For stock acquisitions (defined as more than 90% stock consideration), the convertible remains outstanding and becomes an obligation of the acquiring / merged company with the conversion price adjusted for the share ratio of the acquisition.
If the issuer is acquired for more than 10% cash, investors will have an option to receive the value of their initial investment (i.e., a put right) or convert the securities and receive the remaining option value in the form of incremental shares. Incremental shares are calculated based on a table of make-whole values, which are established at issuance and are intended to protect investors from losing value (option value and coupons) if the issuer is acquired and convertible ceases to exist prior to the stated maturity date.
There are no adjustment provisions for situations where the issuer acquires other companies.
What are the most significant risks in convertible bonds?
Convertible bonds can be an attractive financing alternative and offer meaningful benefits to other financing options, but issuers should be cognizant of the considerations:
- A convertible is a debt instrument and needs to be repaid in cash at maturity if stock does not perform
- A convertible can cause stock dilution in the future
- Final cost of capital is dependent on future stock price performance
- Convertibles are subject to protections – for example, dividend payers will need to understand that convertible investors will receive adjustments for future common stock dividend payments or dividend increases
The above list is not exhaustive and potential issuers should reach out to Matthews South to discuss implications that pertain to them. Investors should read the relevant offering memorandum or prospectus for a description of material risks associated with any new issuance of convertible bonds.
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