Convertible Debt

Convertible Debt

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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.

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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) and a cheap one if firm does well (conversion – holders buy stock in a higher stock price).

According to Miller and Modigliani theory, if financial markets are perfect we don’t know what will happen in the future (if our firm will do badly or well) and so corporate financial policy (including hedging policy) is irrelevant between straight debt, equity or convertible bonds. Thus, firms should be indifferent in choosing among them.

It is indeed the consensus of these and other scholars that the cost of capital and the value of the firm cannot be affected by issuing hybrid securities instead of straight debt or equity.


3.     Why do firms issue convertible debt?

Hence, if convertible debt is not a cheap form of financing, why is it issued? The practices by financial executives that are mentioned before are in direct conflict with financial theory.

Firms that issue convertible bonds are different from other firms. Companies that were more likely to benefit from convertible financing had greater earnings volatility, were smaller with higher levels of financial leverage and more growth potential (Payne1977). The kind of company that uses convertibles provides clues to why they are issued.

The literature concerning convertible bonds offers some suggestions about why they might be good strategy.


i)      Matching Cash Flow

If financing is costly, it makes sense to issue securities whose cash flows match those of the firms. A new, risky firm might prefer to issue convertibles because these will have lower initial interest costs. When the firm is successful the convertibles will be converted. This causes dilution, but it occurs when the firm can most afford it (Ross et al. Corporate Finance).


ii)      Risk Synergy

Ross et al. also argue that convertible debt is useful when it is very costly to assess the risk of the issuing company. Convertible bonds can somewhat protect against mistakes of risk evaluation. If the company that someone invested turns out to be a low risk company, the straight bond component will have high value and the call option will have low value . Respectively, if the company turns out to be a high risk one, the straight bond component will have low value and the call option high value.


iii)      Risk-Shifting / Agency Costs

Convertible debt can be used to eliminate the risk-shifting problem. Corporate management can encounter a conflict of interest problem in dealing with bondholders. Since the corporate manager (agent) represents the interests of stockholders and bondholders, there is a potential for conflict between the manager and bondholders or equivalently, between the manager and the bondholders’ trustee. This will be the case if it is possible for the manager to take actions that benefit one group (shareholders) and are detrimental to the other. Basically, the conflict occurs because both the bondholders’ trustee and the agent behave in accordance with their own self interests. The agency problem considered here is encountered by the corporate management in selecting among mutually exclusive investment projects.

This happens because straight bonds create an incentive for equity holders to force the agents to adopt high risk projects, since high risk projects with negative NPV reduce the value of the firm and transfer wealth from bondholders to shareholders. On the other hand, creditors (bondholders’ trustee) have an incentive to force the firm into low risk activities in order to preserve their wealth. As Jensen and Smith noted “the value of the stockholders’ equity rises and the value of the bondholders’ claim is reduced when the firm substitutes high-risk for low-risk projects.”

However, because convertible bonds have an equity component, less expropriation of wealth can occur when convertible debt is issued instead of straight debt. Moreover, since convertible debt contains an option feature, its value increases with risk. In other words convertible debt can mitigate agency costs and the risk shifting problem that derives. As Ross et. al. states one implication is that convertible bonds have less restrictive debt covenants than straight bonds.


iv)      A good financing strategy

Firms desire equity capital and convertibles are an expedient way of selling common stock. In addition, firms desire more debt and by adding the convertible feature in a straight bond gives them the opportunity to borrow in lower interest costs. The use of a conversion privilege as a "sweetener" to obtain lower interest rates on debt is well known in financial markets. Purchasers feel that the conversion privilege is worth at least as much as the difference in interest on a straight bond and interest on a convertible.

Brigham (1966) tried to determine which of the above two reasons was predominant in firm's decisions to issue convertibles. He sent questionnaires to 22 firms. Of these, 73 percent indicated that they were interested in obtaining equity, and the remaining 27 percent stated that they were simply interested in "sweetening" a debt issue. Each one of the respondents indicated that they had financing alternatives at reasonable costs. They stated that they could have issued common stock at prices ranging from 2 to 5 percent below the market price and the straight debt alternative would have increased interest costs only to 1 percent. They were in no way forced to use convertibles. Thus, it may be concluded that the firms were in a position to take advantage of the best financing strategy package available. That is using convertible debt.


v)      Backdoor Equity / Delayed Equity

Firms use convertible debt for many reasons but an important reason is as a way of avoiding adverse-selection problems – caused by asymmetric information.

The situation is that management has investment opportunities that they believe to be highly profitable, in contrast with the market that is either is not aware of these opportunities or it is more pessimistic concerning the profitability of the projects. The price of the firm's stock will reflect the opinion of the market and not of management. If the firm has reached its capacity for long-term secured debt and the flow of internal funds is not sufficient to support the proposed projects, then the management would prefer to issue new shares of common stock. But the price of the new shares will reflect the market's more pessimistic view and the present shareholders will not receive the full benefits of the investment. This is an appropriate scenario for management to make a delayed equity issue. That is, issue convertible bonds with a conversion price approximating the value of the stock if the market agreed with management on the value of the investments. If the investment opportunities turn out as well as management expected the market price of the stock will go up and the bonds can be called (forced) and converted. Thus, management will be able to issue delayed (backdoor) equity and the present shareholders receive the benefit of the profitable investment .
Stein (1992) argues that good firms (that are more likely to have success) will issue debt, bad firms will issue equity, and medium firms will issue convertibles . He also mentions that firms with high costs of bankruptcy (example higher R&D), and firms with higher than industry average debt ratios are more likely to issue convertibles if they expect good times ahead and can force conversion. By issuing convertibles now with a call provision, firms can issue equity (by forcing conversion) which will allow the firm to raise more debt if they need it in the future.
In general, when the success of a project is unknown, convertible bonds allow firms to raise new debt in the future if successful, if not successful, then controls free cash flow problem rather than allowing further investments in it.

vi)      Other reasons
The interest is tax deductible. Because convertible bonds are a form of debt the coupon payment can be regarded as a cost of the business and can therefore be used to reduce taxable profit.
Self liquidating. When the share price reaches a level at which conversion is worthwhile the bonds will normally be exchanged for shares so the company does not have to find cash to pay off the loan principal – it simply issues more shares. This has obvious cash flow benefits. However the disadvantage is that the other equity holders may experience a reduction in earnings per share (equity dilution).
Fewer restrictive covenants. The company has greater operating and financial flexibility than they would with a secured debenture. Investors accept that a convertible is a hybrid between debt and equity finance and do not tend to ask for high-level security, impose strong operating restrictions on managerial action or insist on strict financial ratio boundaries.
Ending, Mayers, D.(1998) proposes that corporations use callable, convertible bonds to lower the issuance costs of sequential financing. Sequential financing helps control over-investment incentives, that can arise if financing is provided prior to an investment option's maturity, but incurs additional issue costs. A convertible bond's conversion option reduces these costs while helping to control the over-investment incentive.


4.     Conclusion

Principles of basic financial theory are in direct conflict with the reasons given by managers to issue convertible debt. Some see convertibles as cheap debt; others view them as a way to raise equity at a favourable cost and with less dilution. While convertibles are not a cheap form of financing, they can lower the cost of capital and thus increase the value of the firm.

Straight debt and equity represent the opposite ends of the spectrum of fixed payment obligations incurred by a firm. Convertible debt on the other hand permits a tradeoff between the fixed payment obligation and the equity component. Issuing convertibles is a more flexible source of finance. Therefore, firms have the opportunity to use convertible debt in various situations and for various reasons.



5.     References

Books

Damodaran, A, Corporate Finance; Theory and Practice, John Wiley & Sons, Inc (2001)

Stephen A. Ross, R.W.Westerfield and J.Jaffe, Corporate Finance, McGraw-Hill (2001).

Articles

Brigham, Eugene F, "An Analysis of Convertible Debentures: Theory & Some Empirical Evidence" Journal of Finance 21, March 1966, pp. 35-54.

B. Payne, N. Rumore and P. Boudreaux: ‘The use of security options to gain strategic financing advantages: Theory and practice’, Journal Of Financial And Strategic Decisions, Volume 7 Number 3 Fall 1994

Brennen, Michael J. and Edwardo Schwartz, "The Case For Convertibles," Journal of Applied Corporate Finance 2, 1988, pp. 55-64.

Copeland, Thomas E. and J. Fred Weston, Financial Theory and Corporate Policy. Addison-Wesley Publishing Co., 1983, pp. 420-423.

Ian F. Tait, hand notes from module “Financial Management and Accounting”, University of Bath (2004-5)

Ingersoll. “An Examination of Corporate Call Policies on Convertible Bonds.” Journal of Finance (May 1977).

Jensen, M., and W. Meckling. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics 3 (1976): 305-60.

Jensen, M. and Clifford S. “Stockholder, Manager, and Creditor Interests: Applications of Agency Theory.” Recent Advances in Corporate Finance . Ed. Edward Altman and Marti Subrahmanyam. Richard D. Irwin, 1985.

Mayers. “Why firms issue convertible bonds: the matching of financial and real investment options.” Journal of Financial Economics 1998 Vol 47 N0. 1. pp 83 – 102.

Richard Fairchild, hand notes from module “Corporate Finance”, University of Bath (2005)

Richard H. Gamble, ‘Convertibles Roll Out in Fleets’, July 2001 Business Finance (BusinessFinanceMag.com)

Richard D. MacMinn, “On the Risk –Shifting Problem and Convertible Bonds”
April 1992
(http://journalofriskandinsurance.org)

Stein. “Convertible Bonds as Backdoor Equity Financing.” Journal of Financial Economics 1992 vol 32, pp 3 – 21.

Internet sites

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