TREASURY ESSENTIALS Convertible Bonds The art of conversion Businesses can benefit greatly from the flexibility offered by convertible bonds. Andrew Moorfield of bfinance.co.uk provides an overview. onvertible bonds are a form of debt instrument that (2) Asymmetry of information combines a standard bond with an equity option. As (3) Timing of cashflow realisation Cwith most bonds, a convertible pays coupons and a (4) Ownership issues principal repayment to bondholders. However, the holder of the convertible bond also has the right to forego these payments in (1) Market inefficiencies order to convert the bond into a pre-specified number of shares Bankers regularly cite ‘market inefficiencies’ to support their of the issuer. The issuer may also have the right to convert the own preference for the particular type (and timing) of security debt obligation into equity. they believe a corporate client should issue. In general, when capital markets are liquid and active, dif- Popularity of convertibles ferent corporate securities will be priced to reflect the market’s The annual value of total convertible bond issuance has risen perceived level of risk in the company. The higher the risk significantly over the last three years. This growth was especial- and the lower the confidence investors have in the company, ly notable last year; in the first eight months of 2000, almost the lower will be the price of a company’s debt and/or equity $74bn of new convertibles were launched, compared to $97bn securities. during the whole of 1999. The validity of the ‘market inefficiency’ argument hinges on This growth stems largely from the flexibility of convertibles. the market incorrectly pricing different classes of securities Compared to other instruments available in the public equity issued by the same company. For example, bonds may be and debt markets, convertible bonds allow treasurers more priced more favourably than equities. Such an occurrence is scope to tailor their funding to their company’s specific require- difficult to justify or identify – therefore it could be argued ments. For example, treasurers can alter the period and value that treasurers should be somewhat suspicious of these The less risky the financing instrument issued by a company, the less likely investors are to under price the instrument of coupon payments and select their own conversion terms and explanations when presented by their bankers. redemption amounts. Relative to other instruments, a convert- ible allows a treasurer to take into account different potential (2) Asymmetric Information scenarios for the company’s cashflow and market value when There is often an asymmetry of information between the com- setting the terms of the issue. pany’s management and the market. This different level of The embedded options contained in convertibles are also information creates the opportunity for a company to issue becoming more esoteric, for instance, offering investors the financing instruments that can monetise this asymmetry. opportunity to convert to the stock of more than one entity (per- The key factors of the asymmetry are the company’s expec- haps reflecting the future plans of the issuer to float off busi- tations on the timing and quantity of future cashflows. Issuing nesses at a later stage). equity at a time when management knows that the market is undervaluing the company will tend to result in excessive dilu- Valuation techniques tion (ie, a loss of value and control for existing shareholders). There are two elements to the valuation of the convertible bond: The company may elect to avoid this dilution by delaying the equity issue. For example QXL, the on-line auction company, G the ‘straight’ portion of the bond (that which pays coupons recently issued a £15m convertible bond to finance its expan- and principal), the valuation of which is a standard discount sion. The rationale for the transaction could be that QXL’s man- of cashflows; and agement believed their equity was undervalued and as a result G the option to forego these cashflows and convert instead into they sought to avoid excessive equity dilution by issuing con- equity, the valuation of which is achieved through an option vertible debt. pricing technique, such as the Black-Scholes formula. (3) Timing of cashflows Why issue convertible bonds? The less risky the financing instrument issued by a company, the The primary question for the issuer is ‘why issue convertible less likely investors are to under price the instrument. As a bonds?’, rather than issue either new equity or straight debt. result, such an instrument is attractive to the company. As debt There are generally four scenarios in which it makes sense for is less risk than equity, there is an implication that a treasurer a treasurer to issue convertible debt: should consider debt to be an appropriate alternative to equi- ty. However, depending on the timing of cashflows, a company (1) Market inefficiencies without a predictable revenue stream (either in terms of 26 The Treasurer – January 2001 TREASURY ESSENTIALS Convertible Bonds amounts or timing) is not in a strong position to borrow money here that zero-coupon convertibles offer issuers the possibility in the debt markets. Convertible bonds may therefore provide of eliminating annual payments all together in return for a a solution. As a company begins to generate operating cash- redemption price set at higher than the issue price. In such cir- flows, but continues to require substantial capital for its invest- cumstances, the aim of the company may be to have as few ments, it could issue debt rather than (dilutive) equity as a bonds reach maturity – and hence an expensive redemption – source of financing. However, if it faces substantial cashflow as is possible. uncertainty and wishes to minimise its financing commitments, Due to the difference in underwriting risk, fees paid to banks it can lower the coupon payment for a given face value by when issuing a convertible bond should be lower than for an offering a conversion option (an embedded warrant) with the equity issue. Although convertible fees should be closer to those bond. This type of convertible offers a means of lowering the for bond transactions, banks will argue that the increasing under-pricing penalty associated with equity (thus minimising range of convertibles that can be tailored to the specific needs excessive dilution) while reducing the risk of financial distress of individual issuers (for example, the use of different types of associated with debt by lowering the coupon obligations. embedded options) means the banks are effectively customis- ing a product. (4) Ownership and control This customisation means the banks are adding considerable The addition of a call provision, which provides the issuer of the value, and it would be excessively punitive not to suggest that convertible debt the right to force the holders of the debt to con- banks deserve a higher remuneration than with a comparable vert to equity, can be of benefit to a treasurer. Such a call pro- plain vanilla bond issue. vision allows the treasurer to effectively delay an equity issue Until recently, underwriting costs for convertibles had rarely until the market value of the company more accurately reflects deviated from a standard 2.5%. However, banks have now bro- its ‘true’ value. As a convertible does carry the obligation of ken rank and competition for mandates has dragged prices regular coupon payments, this can increase the risk of financial down. In particular, treasurers launching deals valued at more distress. In these circumstances, a call provision gives the issuer than £1bn are likely to be able to negotiate a discount. Such a the right to force bondholders to exercise their conversion discount can be transparent through a reduced underwriting option after a given period of time. This will lower the compa- fee or via a less transparent subsidised interest rate swap (if the ny’s financial commitments because the treasurer can replace issue is to be swapped). debt with equity. Equally, the treasurer can determine the timing At present, banks are likely to open negotiations at about of an equity issue and so influence both the ownership and con- 1.95%–2%, but a more aggressive treasurer (with significant trol of the company. and attractive banking business) may feel they can match One of the most important trends over the past few years has been the high level of exchangeable bond issuances A company issuing this kind of convertible bond could not recent rumoured fees of below 1.5%. Treasurers with a more only obtain lower coupon payments than straight debt, but also limited scale of banking business may find that banks will would be able to force conversion. Here, a treasurer can avoid charge underwriting fees of up to 3%. coupon and principal repayments beyond a certain time peri- As with most bank negotiations, treasurers can expect some od. The call provision reduces the risk of financial distress to the fee flexibility. But bankers will be resistant to aggressive fee issuer while still delaying the issuance of equity if management deductions – bankers will (quite rightly) point to the added- believes the market is undervaluing the company. value nature of their advice and the complexity of the proposed One of the most important trends over the past few years has transaction. been the high level of exchangeable bond issuances. Exchangeable bonds are issued by one company, but are con- Selection criteria vertible into the shares of another. Such structures provide an When pressed, many bankers state that there is a view that it is ideal way for corporates involved in restructuring to sell down easier to win a mandate on price than to lose one. However, their equity holdings at an attractive price.