When issuing a convertible bond, treasurers should take advantage of their structural flexibility. Mark Dalton explains how
Part of the appeal of convertible bonds as a financing tool lies in their structural flexibility, since the investor base for convertibles is willing to accept non-standard structures.
But this same flexibility can also be a source of frustration for issuers trying to determine the best structure for them, or when comparing different ideas and pricings.
Let’s take it as given that an issuer has a known credit curve, dividend yield (or planned dividend payments and a known share price) and share price volatility. Let’s also assume that the shares are sufficiently liquid and borrowable as to allow any investor that wished to hedge to do so.
Common features
In that case, we have six common structural features that impact on the pricing of a convertible, as well as a number of secondary ones. The common ones are:
- Time to maturity – the longer the maturity, typically the higher the coupon (as the bond value typically falls, and the option value increases, but usually not as quickly).
- Coupon – the higher the current coupon paid, the higher the value of the bond component.
- Conversion premium – the higher the conversion price relative to the current share price, the lower the option value.
- Investor put option(s) – if investors have a right to have their bond redeemed early at par, the value of the bond component increases (without decreasing the option value).
- Issuer call option – if the issuer has a right to call the bonds early (typically to force conversion), this decreases the option value – the earlier the call can be exercised, and the less restrictive the share price test, the greater the impact.
- Dividend adjustment threshold – the lower the dividend that can be paid by the issuer without convertible investors being compensated with a reduction in the conversion price, the greater the option value.
Less common features
A number of other, less common, features are also seen in this market:
- Coupon versus yield – some convertibles pay a coupon of less than the yield on the bonds – the difference is paid in the form of an above-par redemption price. This structure reduces the bond value (as the future payments are typically discounted at a higher rate due to an upward-sloping yield curve) and the option value (as the stock price has to exceed the conversion price multiplied by the redemption price before an investor would choose to convert).
- Conversion price resets – this feature is seen infrequently in Europe, although it is more common in Asia. For a period of time, if the share price does not perform well, the conversion price will be reduced to compensate investors. Adding such a feature increases the chance of the bonds ultimately being in the money, and thus increases the option value.
- Takeover protection clauses – there are a number of different takeover protection clauses used in the convertible market, and while few convertible investors attribute significant differences in value to them upfront, some clauses offer investors a chance of a windfall gain upon a future takeover, and therefore may add value upfront (particularly if an issuer is seen as a takeover candidate).
- Seniority in capital structure – most convertible bonds are senior, unsecured liabilities of the issuer, but some can be structured to be subordinated to other senior unsecured debt, or may be unsecured when an issuer uses significant amounts of secured debt (for example, in the real estate sector). A form of structural subordination can also be caused by having the maturity date of the convertible after that of other outstanding debt, or structuring a negative pledge clause that would allow significant amounts of secured debt to be added to the capital structure, effectively subordinating the convertibles in future.
Issuers need to be aware of the impact of these points when structuring a new convertible, and should think about which are most important and how to trade off the less important features to achieve the desired outcome. It is important to remember that some of these features have certain outcomes (for example, a fixed coupon, until the first call date), while others have potential costs (for example, a redemption premium, which may never be paid in cash). Finding the right balance will maximise the chance of the convertible providing a positive experience to all parties during its life.
About the author
Mark Dalton is the founder of Conv-Ex, an independent advisory firm specialising in convertibles and equity derivatives.
E: mark.dalton@conv-ex.com
W: www.conv-ex.com
