Convertible Debt

1. Convertible Debt

Companies have to ways in raising money and financing their plans: issue debt or equity. Debt comes in the form of loans and equity in the form of shares. There is a wide range of methods for both ways, with different instruments and multiple options. In this study we will focus on debt and especially in convertible debt. A convertible debt is a loan that can convert to equity under certain circumstances, usually at the holder's discretion.

A convertible debt is usually issued in the form of convertible bonds, which is similar (but not the same) to a bond with warrants. A warrant is a certificate, usually issued along with a bond or preferred stock, entitling the holder to buy a specific amount of securities at a specific price, (usually above the current market price at the time of issuance), for an extended period, anywhere from a few years to forever. A bond is a certificate of debt that is issued by a government or corporation in order to raise money with a promise to pay a specified sum of money at a fixed time in the future and carrying interest at a fixed rate. So, a convertible bond is a bond with warrants with the only difference that the latter can be separated into different securities whereas a convertible bond can't. A convertible bond gives the holder the right to exchange it for a given number of shares of stock anytime up to and including the maturity date of the bond (Ross, Westerfield, Jaffe, Corporate Finance).

Convertible bonds are hybrid instruments: they are never as good as bonds when yields fall and they never perform as well as stocks in a bull market , but they always deliver better returns than the mix of the two(Ahmed Talhaoui, Incisive Media Investments Ltd. 2005). From an issuer point of view, they look interesting as they are cheap (the coupon is usually lower than for conventional bonds) and it is a way of selling stock at a premium (as at issue, the conversion option is out of the money). Convertibility is usually added as a deal sweetener in bonds to attract investors.

For the lender a convertible debt creates a win-win situation. If the company is a success, the lender gets to participate as an equity investor. If the company does badly and can't foresee any exit opportunity, the lender can still call for repayment of the loan at the end of the term.

2. Issuing convertible debt is not a cheap form of finance

Many people think that issuing convertible debt is a cheap form of finance for companies, and in practice many financial managers prefer to issue convertible debt than straight bonds or equity when they want to raise funds. The driving reason is that convertible debt has historically lower interest rates than straight debt, and it offers higher value to the issuer.

The lower coupon rates, in comparison with the straight debts rates, indicate that the bonds yield is lower and that the company won't pay a lot of money to the holder. Theoretically, an investment-grade issuer might expect to pay about 7 percent on a straight three-year debt today, about 2 percent above the risk-free rate, while a convertible issue with a 30 percent to 35 percent conversion premium might carry an interest rate of just 1.5 percent (R.Gamble 2001). On the other hand a convertible bond offers higher value than straight debt to a company since it's more attractive to investors. The conversion option - added as a sweetener- makes it more attractive and speculative than buying stocks or straight bonds. Investors are in general optimistic enough in the long term to settle for a low-yield fixed-income instrument that rewards them for converting to common stock if the stock price rises between 20 percent and 40 percent. That's certainly what investors expect when they take a yield of 1.5 percent.

In addition, finance executives in need of funds are unwilling to sell stock if the prices are low, and are moving to convertibles to take advantage of low interest rates now and higher stock prices in the future. So in general, companies are issuing convertible bonds as a cheap source of debt and to raise future equity at better prices than the stock market allows. According to R.Gamble (2001) "in most cases, convertibles are the preferred option, because they offer cheaper opportunistic funding, diversification, a volatility play and strategic financing. Conventional bonds are a cheap way of financing"

Is this the case? Copeland and Weston are clear: "Convertible bonds are not cheap debt. Because convertible bonds are riskier, their true cost of capital is greater (on a before tax basis) than the cost of straight debt. Also, convertible bonds are not a deferred sale of common stock at an attractive price."

Brennen and Schwartz described as a "popular misconceptions" the fact that convertible bonds generally carry coupon rates lower than market rates on straight debt and that they allow companies to sell stock at a premium over the current price. Their empirical study concluded that the real cost of convertible debt should be thought of as a weighted average of the cost of straight debt and the higher cost associated with the conversion or equity option. They further concluded that the continuing popularity of convertibles lies in their insensitivity to company risk. (Payne, Rumore, Boudreaux: 1994)

Ingersoll also concluded, that the true cost of capital cannot be lowered by issuing hybrid securities in lieu of straight debt or equity, because the lower cost of convertible debt would be offset by signaling a greater degree of company risk.

Moreover, the Miller-Modigliani convertible debt irrelevance theory shows that manager's expectations about the future of their firm, and measurement perceptions of each financial instrument are the reasons that make convertible debt attractive as a cheap form of finance. As Figure 1 illustrates, for the firm-issuer of a convertible debt if the firm does badly (stock price falls) there will be no conversion from holders. If firm does well (stock price rises), holders will convert their right to gain shares of the firm, and so we will have dilution in the equity. Compared with straight bonds in the two cases, convertible bonds are a cheap form of finance if firm does badly (no conversion - just a lower interest rate bond) and an expensive one if firm does well (conversion - dilution in equity, holders buy equity in a below market price). Compared with equity financing, convertibles are an expensive form of finance if firm does badly (no conversion, holders don't gain equity - and firm lost its opportunity to raise money by issuing equity when stock price was higher)