Lost among record levels of issuance of both investment grade and high yield bonds, activity is starting to percolate in a quieter corner of the capital markets: the convertible bond market. Convertible bonds are hybrid financing vehicles. They’re issued as a bond, but they include an option for the bondholder to convert them into a specified number of shares of common stock in the issuing company. This embedded option, sold by the issuer to the investor, enables the issuer to lock in a lower coupon than it could for equivalent straight debt, and it enables investors to receive current income in the form of cash coupons while potentially participating in the upside of the underlying shares.
Over the past few years, historically low interest rates have made traditional bonds very attractive to issuers. Many have opted to lock in low coupons in the straight debt markets, rather than issue convertible bonds that would potentially result in future dilution of their common stock. Corporate America’s focus on more traditional bonds has limited the supply of new convertible offerings. Recently, however, favorable market conditions have led to a surge in new convertible offerings, and the trend may be just getting started.
This shift has been driven by several factors. Because convertibles include both bond-like and equity-like features, the combination of low interest rates and equity prices at all-time highs makes them very attractive for issuers willing to look beyond more-familiar financing options. Recent convertible issuers have locked in low coupons and attractive conversion prices—but these favorable market conditions are hardly breaking news.
Why, then, have offerings recently increased? Equity prices are part of the explanation. A more subtle factor is the 100 basis point (bps) increase in interest rates since early May, which has led to higher coupons for straight bonds. Historically, issuance of convertible bonds has increased in rising-rate environments (see Figure 1, below), as convertible pricing is less impacted by rate increases than is equivalent straight debt. Furthermore, the higher volatility in the high yield and investment grade bond markets in May and June created uncertainty for issuers and convinced some to reconsider the timing of opportunistic financings. These factors, coupled with the strong demand from convertible investors seeking to replace older offerings that have recently matured, make it hardly surprising that some potential issuers of straight debt are considering other financing alternatives.
Flexible Arrow in the Corporate Finance Quiver
When confronted with a financing need, management teams tend to gravitate toward familiar mainstays, such as traditional loans, bonds, and common equity. However, convertible bonds are regularly used to address the same types of needs: growth capital, refinancing, acquisitions, restructuring, and share repurchase programs.
Pricing terms for convertibles vary widely based on factors such as the issuer’s credit profile and characteristics of the underlying equity. Typical terms for recent offerings have included maturities of five to seven years, coupons averaging 3.00 percent, and conversion premiums from 10 percent to around 50 percent.
From the issuer’s perspective, investors’ willingness to accept a wide array of coupon and conversion premium combinations provides flexibility to target a specific cash coupon or conversion premium.
But issuers need to understand that cash coupons and conversion premiums are closely correlated. A company seeking to lock in the highest possible conversion price can do so by offering investors a higher coupon.
This makes sense intuitively: An option struck further above the current share price is less valuable than one that enables investors to participate in the upside of the shares sooner. As a result, investors purchasing a higher-premium convertible will require a higher coupon to achieve an equivalent value on the overall, bundled terms of the convertible bond. (See Figure 2, below.)
31 Flavors of Financing
The flexibility afforded by convertibles extends far beyond the tradeoff between coupon and conversion premium. A number of strategies are available to help issuers of convertibles address other specific corporate finance needs. For example:
Objective #1: Maximize Efficiency Of Sizable Equity Financing Solution: Concurrent Common Stock and Convertible Offering
Issuers looking to raise significant amounts of equity financing can offer convertibles simultaneously with common shares. This strategy increases the overall efficiency of an offering by simultaneously tapping multiple markets and distinct investor bases. The convertible component is typically issued as a “mandatory convertible.” A mandatory convertible differs from a convertible bond in that conversion to shares is required, not optional.
Suppose, for example, a potential issuer wants to raise $1 billion and its share price is currently $100.If it raised the full amount by issuing common stock, it would place 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 potentially reduce the overall share dilution. Common investors would need to absorb only 5 million shares up front ($500 million / $100). Mandatory convertible investors would receive a security that would pay a preferred dividend for three years (typically 5 to 7 percent per year) then convert into shares at one of a set of predetermined prices.
Let’s say the conversion premium of the mandatory convertibles is 20 percent. If the share price ends up above the conversion price of $120 after three years, investors will receive 4.17 million shares ($500 million / $120). If the share price is below the initial offering price of $100, the mandatory will convert to 5 million shares. At prices between $100 and $120, investors will receive between 4.17 million and 5 million shares. In the scenario with the most bullish stock price gains, the issuer will face less share dilution—it will issue over 800,000 fewer shares—under a concurrent financing than it would in a comparably sized equity financing.
Given the certainty of conversion, rating agencies assign a very high degree of equity credit to mandatories—up to 100 percent—which means that although it attracts convertible bond investors, a mandatory convertible does not impact a company’s credit rating in the way other bonds do. In fact, the simplest mandatory is structured as preferred stock rather than as a bond. Mandatory convertibles therefore provide issuers the opportunity to protect their ratings while offering something other than straight equity. In many cases, mandatories are also designed to achieve partial tax deductibility of the coupons.
Objective #2: Opportunistic Share Repurchase Solution: Convertible-Funded Share Repurchase