• Nil Acar

Convertible Bonds - Somewhere between Equity and Debt Financing

Convertible bonds are usually fixed-rate bonds that give their holders the right to convert their bonds to another instrument. This instrument is usually common stock, but can be another debt or equity instrument of the issuer. Convertible bonds can be used as a relatively cheap way of financing by the issuers because of the value of the option to convert bonds into equity. These bondholders are entitled to relatively low interest when compared to plain vanilla bonds. Convertible bonds have similarities with plain equity financing–for example, companies can rely on their “equity story” to lure investors. In the event of a plain equity offering, there is a greater expectancy of price fluctuation (e.g. due to dilution and underpricing). But, unlike in a plain equity offering, the stock price of the issuer does not fluctuate as much with a convertible bonds issue since there is no current dilution. There is a relatively small fluctuation at the time of issue due to the possible future dilution of shareholders at conversion.

According to Bloomberg tradebook, for the past three years, an average of $57 billion and 250 issues per year have taken place globally. As of May 2016, $22 billion and 71 issues took place for the year 2016–the reason for decline in these figures is mainly attributed to the Federal Reserve’s tightening policies that result in an interest increase. A convertible bond issue is a more popular instrument in international markets than domestic markets. The United States and Japan have a local market for convertible bonds, but a significant majority of the convertible bonds are issued through Rule 144A/Regulation S safe harbors.

A convertible bond initially performs like a plain vanilla bond until conversion–the issuer is usually required to make semi-annual coupon payments to the bondholders (except for true zero convertible bonds). Conversion may be made before the maturity or at the maturity depending on the terms and conditions. At the conversion, the bondholder has the option to receive stock instead of the benefits of the bond. Usually, conversion is granted as an option right to the bondholder, but conversion may also be conditioned upon certain trigger events under the terms and conditions. Contingent convertible bonds (CoCo Bonds) are an example. Banks looking to support their capital adequacy ratios commonly resort to CoCo bond issuance. A bank can issue convertible bonds that qualify for Tier 1/Tier 2 capital and these bonds can be converted automatically into the bank’s stock if the bank’s equity is drained, or its capital adequacy ratio falls under certain ratios.

The conversion price is usually a pre-determined price at which the converting bondholder will acquire the stock and it is usually set with a 10%-35% premium over stock market price on the day the bonds are priced. Setting the price beforehand with a premium over the market price may be advantageous for the issuer when compared to a plain equity financing. This is especially true if the issuer has reason to believe that its stock is undervalued at the time the bonds are issued. When the conversion price is higher, investors require higher coupon interest payments and vice versa.

The conversion price may be fixed, or may be adjusted upward or downward, upon the occurrence of certain corporate events that affect the dilution amount of bondholders and existing shareholders at the time of conversion. The adjustment amount is determined under anti-dilution adjustment formulas in the terms and conditions of the convertible bond and the purpose is to protect the economic value of bondholders’ investments. Corporate events which give rise to potential adjustment of conversion price include: dividend payment, stock split, stock combination, distribution of rights, options warrants or any right entitling stockholders to subscribe stock lower than market price, tender offers, exchange offers, and repurchases of stock before the exercise of conversion right.

Another important feature of convertible bonds is net share settlement. At the time a bondholder exercises her option to convert her bonds into stock, the issuer is required to provide stock equal to the conversion value (which is determined by taking into consideration the conversion price). To perform its obligation, the issuer can issue new shares or give the shares it repurchased from the market to the bondholder. One of the biggest concerns of existing shareholders is the amount of future dilution when the issuer issues new shares to perform her obligation to bondholders. Net share settlement is a method to limit the number of shares an issuer can issue for bondholders. With net share settlement, an issuer can pay the principal amount of the bond in cash at the time of conversion and the excess of the conversion value in stock instead of paying the whole lump sum in stock. This limits the dilution of existing shareholders.

All in all convertible bonds, due to their hybrid nature, carry both equity and debt-like features. Convertible bonds have advantages over plain vanilla debt offerings due to lower interest rates. Convertible bonds also have advantages over plain equity offerings because they face less vulnerability to stock price fluctuations. However, structuring a convertible bond is complex and a lot of important features such as the future dilution of stockholders and conversion price have to be taken into account.

Nil is a Corporation LLM student with a dean's scholarship from Istanbul. Prior to joining NYU, she worked in the White & Case Istanbul office in the capital markets department.

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