Lost among record levels ofissuance of both investment grade and high yield bonds, activity isstarting to percolate in a quieter corner of the capital markets:the convertible bond market. Convertible bonds are hybrid financingvehicles. They're issued as a bond, but they include an option forthe bondholder to convert them into a specified number of shares ofcommon stock in the issuing company. This embedded option, sold bythe issuer to the investor, enables the issuer to lock in a lowercoupon than it could for equivalent straight debt, and it enablesinvestors to receive current income in the form of cash couponswhile potentially participating in the upside of the underlyingshares.

Over the past fewyears, historically low interest rates have made traditional bondsvery attractive to issuers. Many have opted to lock in low couponsin the straight debt markets, rather than issue convertible bondsthat would potentially result in future dilution of their commonstock. Corporate America's focus on more traditional bonds has limited the supply of newconvertible offerings. Recently, however, favorable marketconditions have led to a surge in new convertible offerings, andthe trend may be just getting started.

This shift has beendriven by several factors. Because convertibles include bothbond-like and equity-like features, the combination of low interestrates and equity prices at all-time highs makes them veryattractive for issuers willing to look beyond more-familiarfinancing options. Recent convertible issuers have locked in lowcoupons and attractive conversion prices—but these favorable marketconditions are hardly breaking news.

Why, then, haveofferings recently increased? Equity prices are part of theexplanation. A more subtle factor is the 100 basis point (bps)increase in interest rates since early May, which has led to highercoupons for straight bonds. Historically, issuance of convertiblebonds has increased in rising-rate environments (see Figure 1,below), as convertible pricing is less impacted by rate increasesthan is equivalent straight debt. Furthermore, the highervolatility in the high yield and investment grade bond markets inMay and June created uncertainty for issuers and convinced some toreconsider the timing of opportunistic financings. These factors,coupled with the strong demand from convertible investors seekingto replace older offerings that have recently matured, make ithardly surprising that some potential issuers of straight debt areconsidering other financing alternatives.

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FlexibleArrow in the Corporate Finance Quiver

When confronted witha financing need, management teams tend to gravitate towardfamiliar mainstays, such as traditional loans, bonds, and commonequity. However, convertible bonds are regularly used to addressthe same types of needs: growth capital, refinancing, acquisitions,restructuring, and share repurchase programs.

Pricing terms forconvertibles vary widely based on factors such as the issuer'scredit profile and characteristics of the underlying equity.Typical terms for recent offerings have included maturities of fiveto seven years, coupons averaging 3.00 percent, and conversionpremiums from 10 percent to around 50 percent.

From the issuer'sperspective, investors' willingness to accept a wide array ofcoupon and conversion premium combinations provides flexibility totarget a specific cash coupon or conversion premium.

But issuers need tounderstand that cash coupons and conversion premiums are closelycorrelated. A company seeking to lock in the highest possibleconversion price can do so by offering investors a highercoupon.

This makes senseintuitively: An option struck further above the current share priceis less valuable than one that enables investors to participate inthe upside of the shares sooner. As a result, investors purchasinga higher-premium convertible will require a higher coupon toachieve an equivalent value on the overall, bundled terms of theconvertible bond. (See Figure 2, below.)

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31 Flavorsof Financing

The flexibilityafforded by convertibles extends far beyond the tradeoff betweencoupon and conversion premium. A number of strategies are availableto help issuers of convertibles address other specific corporatefinance needs. For example:

Objective#1: Maximize Efficiency Of Sizable Equity FinancingSolution: Concurrent Common Stock and ConvertibleOffering

Issuers looking toraise significant amounts of equity financing can offerconvertibles simultaneously with common shares. This strategyincreases the overall efficiency of an offering by simultaneouslytapping multiple markets and distinct investor bases. Theconvertible component is typically issued as a “mandatoryconvertible.” A mandatory convertible differs from a convertiblebond in that conversion to shares is required, not optional.

Suppose, for example, a potentialissuer wants to raise $1 billion and its share price is currently$100.If it raised the full amount by issuing common stock, it wouldplace around 10 million new shares with equity investors. If,instead, the issuer offered $500 million worth of common stock and$500 million worth of mandatory convertibles, it could potentiallyreduce the overall share dilution. Common investors would need toabsorb only 5 million shares up front ($500 million / $100).Mandatory convertible investors would receive a security that wouldpay a preferred dividend for three years (typically 5 to 7 percentper year) then convert into shares at one of a set of predeterminedprices.

Let's say theconversion premium of the mandatory convertibles is 20 percent. Ifthe share price ends up above the conversion price of $120 afterthree years, investors will receive 4.17 million shares ($500million / $120). If the share price is below the initial offeringprice of $100, the mandatory will convert to 5 million shares. Atprices between $100 and $120, investors will receive between 4.17million and 5 million shares. In the scenario with the most bullishstock price gains, the issuer will face less share dilution—it willissue over 800,000 fewer shares—under a concurrent financing thanit would in a comparably sized equity financing.

Given the certaintyof conversion, rating agencies assign a very high degree of equitycredit to mandatories—up to 100 percent—which means that althoughit attracts convertible bond investors, a mandatory convertibledoes not impact a company's credit rating in the way other bondsdo. In fact, the simplest mandatory is structured as preferredstock rather than as a bond. Mandatory convertibles thereforeprovide issuers the opportunity to protect their ratings whileoffering something other than straight equity. In many cases,mandatories are also designed to achieve partial tax deductibilityof the coupons.

Objective#2: Opportunistic Share Repurchase Solution: Convertible-FundedShare Repurchase

Issuers can also capitalize on the enhanced stock liquiditysurrounding the pricing of a convertible to repurchase shares.Typically, some portion of convertible investors willsimultaneously buy the bonds and sell some common shares short inorder to hedge against the equity exposure embedded in theconvertible. This creates an opportunity for the issuer to step inand repurchase those shares at the time the offering is priced. Ifthe issuer doesn't step in, the convertible investors will simplysell the shares into the market. By stepping in, the issuer can notonly achieve price certainty on the repurchase price, but in mostcases also repurchase shares more quickly than through an openmarket repurchase program. Given that the conversion price is basedon the issuer's share price at the end of the marketing period, anyreduction in the amount of potential selling activity helps theissuer maximize its conversion price. Recent users of this strategyhave allocated 10 percent to 20 percent of the offering proceedstoward repurchasing shares.

Objective#3: Create a Debt Substitute Using The Convertible Market
Solution: Convertible Plus Call Spread Overlay

Most traditional convertiblebonds have conversion premiums that range from 10 percent to 50percent above the issuer's current share price, averaging 30percent. At higher conversion premiums, pricing becomes lessefficient for the issuer. Given that most issuers are seeking thebest of both worlds—a low cash coupon coupled with the highestpossible conversion premium—how can issuers achieve a high premiumwithout impacting pricing efficiency?

The solution formany is a financing strategy developed by the investment bankingcommunity. Referred to as a “convertible with bond hedge andwarrants” transaction, or more generically as a “call spreadoverlay,” this strategy consists of three components (see Figure3):

First, the issuersells a plain-vanilla convertible bond with a traditionalconversion premium (for example, 30 percent above the current shareprice) to convertible investors.

Second, the issueruses a portion of the proceeds to purchase a hedge from theunderwriting bank(s) of the embedded call option sold in theconvertible. The hedge is a purchased call struck at the conversionprice of the convertible bond (+30% in this example). The hedgeeliminates dilution that the issuer might otherwise face if thebonds convert. If convertible investors exercise their rights toexchange bonds for shares, the underwriters will deliver shares tothe issuer, which can then be used to satisfy the issuer'sobligation to investors. Economically, the combination of thesefirst two steps creates synthetic straight debt.

Finally, the issuerseparately sells call options to the underwriters that are struckwell above the +30% conversion price (for instance, at 75 percenthigher than the current share price). The number of warrants soldis the same as the number of shares underlying the convertible, andthe maturity of the warrants is typically slightly longer than thematurity of the convertible bond. The proceeds from the sale ofthese warrants partially offsets the costs of the purchasedhedge.

When all three stepsare combined, the issuer has used a portion of the initial proceeds(typically 6 to 10 percent) to raise the effective conversionpremium (from +30% to +75% in this case). The issuer hasessentially used the convertible market to create a debt-likefinancing with a low cash coupon and significantly reduced theprobability of dilution.

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GettingUnder the Hood

Given the number of product variants and potential corporatefinance applications, how does a management team efficientlycompare convertibles with more familiar financing strategies?Fundamentally, any financing instrument must fit into the issuer'slong-term financial and strategic objectives. Among other things,the issuer must consider its intended use of the proceeds, itsdesire to add leverage to the balance sheet, and the potential forfuture share dilution. Management should be sure to scrutinize howproduct-specific features interact with broader corporate financeobjectives in terms of:

• Financialflexibility. Most issuers give themselves theflexibility to choose whether to settle a convertible in cash,shares, or a combination if the share price ends up above theconversion price. Many elect to settle at least the principalamount of a convertible bond in cash; a few convertible bonds haveeven hard-wired the documents to settle everything incash. While this settlement mechanism significantly reducesshare dilution, it does create a future cash refinancing obligationthat must be factored into the issuer's long-term financingplan.

• Dilution. Theability to establish a conversion price well above the currentshare price reduces potential dilution relative to a traditionalequity offering. However, issuers should keep in mind thatconvertibles include standard provisions that adjust the conversionprice in the event of stock splits, spinoffs, tender offers,changes in dividends, and other corporate finance events. Suchadjustments could impact the degree to which an outstandingconvertible bond causes future share dilution.

• Accounting. Issuers that incorporatethe flexibility to settle the principal amount of a convertiblebond in cash are also required to bifurcate the security into“debt” and “equity” components for reporting purposes. The endresult is (non-cash) interest expense in addition to the statedcash coupon.

Convertibles are ahighly flexible form of financing that can address a wide array ofcorporate needs. Current market conditions present a clearopportunity for issuers, and recent issuers have gotten ahead ofthe curve to lock in attractive terms. But the product does haveits own distinct terminology and nuances, and it is initially lessfamiliar to most finance teams than other forms of financing.

When a companyunderstands that it has myriad options for issuing convertiblebonds, the question becomes how to compare the flexibility providedby convertibles against the time required to evaluate the productfor most first-time issuers. The good news for prospective issuersis that convertibles have been around in some form for decades, andboth traditional convertibles and the more specialized strategiesdescribed above are well-understood by the legal and accountingcommunities. To the extent that further analysis is warranted,independent advisors can also help management teams work throughthe nuances of these products.

Management teams considering usingconvertibles should ensure that they invest the necessary time, andengage advisors early in the process, to make the most of theproduct line's flexibility. It is noteworthy that there is a longhistory of repeat issuers in the convertible market. Perhaps thatis the most telling sign that management teams who put in the timeto understand this vehicle view the effort as worthwhile.

Greg Holden is aDirector with EAMarkets LLC, a corporate finance andcapital markets advisory firm based in New York City.Holden has over 12 years of experience structuringequity-linked and equity derivatives securities.

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