The Economy

Bond Market Opens Up to Convertibles

Super-low interest rates and the attraction of an equity upside have investors eager for convertible debt, but such instruments have drawbacks for ...
Vincent RyanDecember 10, 2012

Relatively few companies have raised debt via convertible bonds this year, but deal pace has picked up in the past few months, especially in the early fall. Sales of the hybrid instruments have a chance to surpass last year’s total of $20.7 billion.

With bond spreads tight and portions of the corporate bond market oversold, the upswing could continue. Investors may quickly scoop up any additional supply of convertible bonds in the coming months, so it’s an opportune time for a CFO to consider them.

There was not much first-half issuance in 2012, so “the market is kind of hungry for the product, and it always helps to have a market that’s eager,” says Chip MacDonald, a partner at Jones Day.

Convertible bonds — which mix features of debt and equity — are only a small part of the bond markets. Just $16.2 billion in corporate convertibles had been issued in 2012 as of October 31, according to the Securities Industry and Financial Markets Assn. And only 191 issues were trading in the U.S markets last week, compared with 1,506 high-yield bonds, according to the Financial Industry Regulatory Authority.

A convertible bond can be exchanged for shares of common stock in the issuing company, usually at a preannounced ratio and at a certain premium to the current share price. It allows investors to participate in equity upside while the company pays a lower interest rate. Despite the equity feature, the interest paid is still tax deductible to the company.

In a low-interest-rate economy, when investors are earning less than 1%–2% nominal yield on bonds, “the [equity] conversion feature can add a lot of juice for the investor while lowering the coupon to the issuer,” MacDonald points out.

But an issuer’s success at selling a convertible bond — at least in current markets — will also depend on whether the financial markets are in a risk-on or risk-off mode, says MacDonald. In risk-on mode, investors like the potential upside from owning equity, and the small yield on the bond means they earn at least some return, he says. In a risk-off period, though, investors may not like the lower yield from a convertible bond and think that the equity upside is limited.

Convertibles come with disadvantages, too. If investors convert the bonds, equity earnings and voting rights are diluted. And while issuers of “straight” corporate bonds pay only principal and interest (regardless of how the company performs), convertible-bond holders can share in any large upside, says Devrim Yaman, professor of finance at Western Michigan University’s Haworth College of Business.

But dilution issues can be offset with hedging instruments, and if the company wants to cap the equity upside to the investor or give itself the option to refinance the debt, it can include a right to call the bond. The call feature would require the investor to either convert to equity or sell the bonds back.

Yaman’s research and that of others have found another negative to issuing convertible bonds: unfavorable share-price reaction. Her most recent study of 700 convertible bonds and 2,500 “straight” bonds found that a company’s share price dropped an average of 2% in the seven days around the announcement of a convertible. Announcement of other bond issuances had no significant share-price drop. “That is an economically important cost for the firm,” says Yaman.

In one example, electronics giant Sony announced a convertible-bond sale in November, and its stock price fell 10% in one day, Yaman points out. Some investors were selling Sony shares and buying the convertibles, despite the bonds’ 0% coupon rate.

Part of the analysis before issuing a convertible bond is what kind of investors are likely to buy it, Jones Day’s MacDonald says. As part of an arbitrage strategy, some investors buy the bond and automatically short the company’s stock, for example, and others may want the equity to try to gain some measure of control over the company or influence the board of directors.

Convertibles aren’t a fit for every kind of company, either. Investor demand and available terms can depend on the company’s industry. Convertibles are more attractive in industries, like technology or medical services, where investors are expecting big equity returns, MacDonald says.

The hybrid instruments also particularly suit start-ups that want to delay the dilution of voting rights and earnings that comes with issuing equity immediately, says Yaman.