Macro market volatility along with a rise in interest rates has had a material impact to all asset classes in US capital markets. As a result, many debt securities (including convertible debt) are trading below par. In this blog post, we review why a potential repurchase of convertible bonds should be a topic for companies to evaluate as they consider how to manage their upcoming maturities. Some key takeaways are:
- A cash repurchase of convertible bonds that are trading at discounts to par offers issuers a way to lock in a significant yield on their cash while de-leveraging the balance sheet
- Execution can be done via open market repurchase or through a private wall cross with existing holders
- If issuers want to maintain flexibility and keep cash on the balance sheet, a refinancing into a new convertible or exchange for equity may be more appropriate options
- This is a core area of focus at Matthews South and we have advised on (and executed) many liability management transactions
Convertible Market Context:
The last few years saw a record amount of issuance in the convertible market — 2020 was the busiest year on record (by volume) with $107 billion of new paper and 2021 was the third busiest year with $93 billion. The sell off in equities coupled with the 20x rise in the Federal Funds Rate over the past year have resulted in many bonds trading at a discount to par. As a result, many issuers are now facing a liability that will require cash repayment in the next 24-36 months.
How Convertible Values Have Been Impacted by the Current Market:
A convertible bond consists of two main components: 1) a discount bond (since the coupon is lower than the comparable non-convertible debt rate) and 2) an option to convert the bond into equity at a pre-determined “conversion price” (a “call option”). To highlight how convertible values have changed due to share price declines and interest rate increases, we will analyze a hypothetical 0.25% convertible with a 57.5% conversion premium issued in late 2021 as an example.
The issuer of that hypothetical bond issued the convertible with a $100 stock price and a conversion price of $157.50. As seen below, at a deep-out-of-the-money stock price of $30 today, the ~2.9x increase in SOFR + Credit Spread or the “All-in Interest Rate” caused the bond portion of the convertible to lose 14.3 points or ~17% of its initial value. This is simply due to the higher discount rate used to calculate the present value of the future cash flows. The effect on the Option Value component is even more exaggerated, as it lost nearly all of its initial value.
| Stock Price | All-in Interest Rate | Convertible Price | Bond Value | Option Value |
|---|---|---|---|---|
|
$100 (At Issuance) |
3.8% |
100.0 |
83.4 |
16.6 |
|
$30 (04/28/2023) |
11.0% |
69.5 |
69.1 |
0.4 |
Rationale for a Cash Buyback:
Most issuers have cash on the balance sheet that can be used for reinvestment in the company, capital return to shareholders, and/or managing debt maturities. Since most convertible bonds are now trading at a discount to par, that cash can be used to lock in a fixed return in excess of the risk-free interest rate. In our above example, a 69.5 trading price has a Yield to Maturity (“YTM”) of 11.0%. Companies may be hard pressed to find investment opportunities with no risk that yield this return over the next 3.5 years. Additionally, the de-levering nature of this transaction can be viewed as prudent to shareholders, especially given some uncertainties around the nature of the economy in the next 12-18 months.
Some companies may want to retain flexibility and decide to refinance or issue equity to address their upcoming convertible maturities. This is an option as well, especially if the cash on the balance sheet is limited; however, a new convertible will most likely be issued with a higher coupon rate and struck off of a lower share price. Equity will avoid the higher coupon payment but will come with heavier dilution. The analysis of what to do is complex, and Matthews South can help navigate the pertinent decisions to come up with a game plan.
How to Execute a Cash Buyback:
There are two main methods for execution: Open Market Repurchase and Private Wall Cross Negotiations with Existing Holders.
Open Market Repurchase will be done by hiring a broker to repurchase bonds on behalf of the company. The company will pay a small commission to the broker to repurchase the bonds at the prevailing market prices. If executed discreetly, investors may not know that the company is in the market until the quarterly disclosure. The main drawback to this method is the speed in which a company can retire a meaningful portion of the bonds. As liquidity in the convertible market is typically limited, this approach is impractical for a buyback in excess of 25% of the outstanding bonds.
Private Wall Cross with Existing Holders offers the company an opportunity to retire a significant portion of the bonds (up to ~70-80% in some cases). Additionally, this process is efficient as it can be completed over a few days. The main drawback here is that the company will have to pay an above market price. For discount bonds, it is not uncommon for companies to pay upwards of 2 to 3 points to buy the bonds back; however, even after adding 3 points to the bond price, many yields may still be attractive (e.g. our hypothetical convertible bond drops from 11.0% to 9.7% YTM). The actual premium paid is a negotiation with investors and can have a material impact to the economics of the buyback to the company. Due to our experience negotiating with investors on behalf of issuers and executing these transactions, Matthews South can help issuers achieve a fair premium for their repurchase transaction.
When a Cash Buyback May Not Be Appropriate:
As mentioned previously, one of the main reasons a company would not execute a cash buyback is because it wants to maintain flexibility. Uncertainties over the next 12-18 months can cause companies to be cautious and maintain elevated near term cash levels, even if it means refinancing later, at potentially less favorable terms.
Secondly, a company may want to buy their equity instead. In our example, the issuer can buy the convertible back, yielding 9.7%, or it can buy its equity, which one may argue is trading at an even greater discount. The breakeven stock price for a 9.7% return is $41.79, which may seem attainable considering the convertible was issued off of a $100 reference price. The main consideration here is that the debt still remains outstanding, and the company will need to address it. Alternatively, financing the share buyback with the issuance of a new convertible would allow the company to preserve its balance sheet cash.
Another reason why a company may not opt to conduct a cash repurchase is that it may have the cash or be able to generate the cash by the time the convertible comes due and it has greater investment opportunities (e.g, re-invest in the business or M&A).
Please reach out to the Matthews South team to discuss the market opportunity for your company and specifically, how we would advise an issuer to structure a cash buyback or exchange for its convertible debt, and execute, in light of its current goals and circumstances.
Personal Views: The views expressed in this report reflect our personal views. This blog post is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. The large majority of reports by us are published at irregular intervals as appropriate in our judgment and ability to produce, so updates may not be made or available even when circumstances may have changed.
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