Convertibles are a widely used but somewhat esoteric avenue of finance for most students. Although covered in upper level fixed income classes, very few students go into investment banking thinking that they want to work in equity-linked markets – everyone wants to do Mergers & Acquisitions or Technology, Media & Telecommunications.
This is a very limited mindset – if you are genuinely interested in finance, several divisions across the bank offer stimulating work where you are able to be one of a limited number of experts in the space and can accordingly command an extremely high bonus structure while working fairly light hours.
For those who want a longer career in the investment bank, stay tuned here. For coverage team and M&A bankers who want to broaden their perspectives, this is a very powerful product for clients.
This is a preliminary dive into convertibles and if there is additional interest we can elaborate on mechanics and complementary products such as call spreads.
What Are Convertible Securities?
Convertibles are financial instruments that are convertible into common equity. Now the most common of these is the convertible bond or convertible debentures. However, a variety of products can be convertible, from preferred shares to hybrid debt.
Convertible bonds pay a cash coupon like normal bonds and have a defined maturity where they have the obligation to repay the par value of the bond. For all intents and purposes – they are bonds, and are treated from a credit perspective as debt. Unless they are explicitly subordinated in the bond indenture (contract), they will be pari passu – or equal in seniority – to the other outstanding debt of the corporate.
However, convertible bonds have an embedded conversion option where at a certain strike or exercise price, it is convertible into a set number of common shares. Generally, this strike will be set to a premium to the current share price, so the company – if it ends up issuing equity via the convertible being converted – is issuing equity at a premium to the current price – which means a lower cost of capital and less dilution for existing shareholders.
Mandatory Convertible Bonds
Conversion can also be optional or mandatory.
Optional conversion means it is up to the holder of the convertible security whether or not they wish to convert the securities to common shares (you have the right, but not the obligation – so a call option on the equity to some extent).
This is more advantageous to the holder because if the equity tanks, they have a more senior fixed income security (or preferred share) that will continue to pay regular coupons. For a mandatory convertible, the security will convert to a set amount of equity at a predetermined time.
When corporates or the general financier is thinking of convertibles, they are usually thinking about optional convertible securities.
Why Do Corporates Issue Convertible Bonds
Corporates issue convertibles to get a funding source with a lower cost of capital than equity (and sometimes debt – assuming that they do not convert, a corporate achieves a lower cost of debt than it would have with a straight bond issue). They are able to monetize the volatility of their equity by selling an option on their stock.
Also, until the security converts, the corporate enjoys the tax deductibility of interest payments (as it is debt) – although this does not apply for convertible preferred shares where distributions are “dividends”.
Obviously, only corporates can issue convertible bonds because other debtholders such as governments or supranational or sovereign agencies do not have any equity/ownership compnent to convert into.
For corporates, convertible bonds are a very useful product that offers excellent flexibility beyond what common equity or a vanilla or straight bond can offer – especially in regards to pricing (ideally, corporates will get a lower coupon on their bond so that they pay less in terms of interest expense).
A straight bond has a number of levers that a corporate can pull to get the coupon down. A shorter duration, more security/collateral, seniority in the capital structure can contribute to a lower coupon (and lower yield for bond investors). Adding optionality that is beneficial to the bondholder such as a put option (putable bond) can also lower yield.
Having a conversion option is even better in terms of structuring flexibility – a corporate can use a conversion option as a sweetener to get a deal across the line to get the longer tenor (later maturity) or lower coupon that they want.
Who Issues Convertibles and Who Invests in Convertibles
The ideal corporate that issues convertibles is on the lower end of investment grade or sub-investment grade/junk where there are large growth initiatives. Growth companies are looking to get a lower coupon on their debt to fund growth or issue equity in a less dilutive manner than with a normal equity raise – because a converted bond essentially means that equity was issued at a premium.
The convertible is attractive to certain bondholders as they get to participate in equity upside should the stock perform well, but also keep the benefits of holding a bond (more likely to get invested money back) if the financial position of the corporate regresses. A convertible that is so far out of the money is called a busted convertible and trades like a straight bond (the option value is essentially 0).
Convertible investors are generally more risk tolerant than straight bond investors (like insurers) and can include hedge funds, mutual funds and other financial institutions that have expertise in the space. Some equity investors may also pick up exposure to a company via convertible bonds. Also, hedge funds like to trade convertible bonds and look for arbitrage opportunities via their conversion options.
Not all investment banks are strong convertible players in the league tables. This is a field that requires specialization and expertise, and banks need to know who the convertible investors are and how the convertible market will react to an issuance. They will need to know how to size the convertible appropriately (how much principal should be issued) versus the current float (shares outstanding) and trading volumes so that the issuance is not disruptive or negative for the underlying equity. As such, investment banks will also market their ability to make markets and move product on the secondary market once the convertible is issued.