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Point at issue - What might convertible bonds say about a company’s financing options?

29/11/2013

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

A little while back, in Hybrid society, we highlighted how businesses across a range of sectors are increasingly turning to so-called ‘hybrid’ bonds as a way of raising capital. More recently, in articles such as Fever pitch, we have offered our thoughts on the re-emergence of other credit instruments such as covenant-light loans, collateralised loan obligations and pik toggle bonds.

To that list we might reasonably add convertible bonds which, while not as contemporary or complicated as some of the above examples, are also enjoying a comeback. This is an interesting development because, although convertibles can be useful tools for company managements in some instances, issuing them is not usually seen as being in the best interests of existing shareholders.

Convertibles operate like normal bonds in that they pay a fixed rate of interest for a period of time, but they can also be converted into shares in the issuing company, at perhaps 30% above the current share price, at some point in the future. As a result of this extra value to the holder, the headline interest cost the company pays from day one will tend to be lower on convertible debt than on the straight ‘vanilla’ variety.

However, while the issuing company may thus save a bit on its interest payments in comparison with issuing vanilla debt, the conversion feature means it is potentially giving away greater future upside from existing shareholders. on balance, therefore, companies typically prefer to avoid issuing convertibles unless they really have to.

We briefly touched on this point in Digging into detail, where Nokia issued convertibles to Microsoft – albeit with specific conditions they would lapse if the associated acquisition of Nokia’s mobile handset division went through. In the same space, Blackberry recently issued convertible debt when its mooted purchase by Fairfax failed while, elsewhere, construction group Balfour Beatty has been another recent issuer.

So why, given it is not really in their current shareholders’ best interests, do companies do it? In general, it tends to be because other sources of financing apart from a new issue of vanilla equity are off the table. In other words, banks do not wish to lend to a company and – quite an indictment in itself in the current environment – public and private investors are unwilling to provide it with other forms of debt.

So the fact a company takes the decision to issue a convertible bond might reasonably be seen as a comment on its other financing options – or at the very least would suggest the rates or terms on offer elsewhere are sufficiently onerous that it becomes something of a toss-up between whether to accept them or introduce the threat of equity issuance into the equation.

Either way, investors need to take note of this apparent resurgence in the popularity of convertible bonds. Here on The Value Perspective, if we felt a company’s shares were undervalued, we would normally prefer to buy those shares than any convertible bonds. Indeed, we might even raise the question of whether the issue of convertible bonds signified a company is potentially in denial about its problems.

Are there companies out there that do not want to own up to their need for new equity and their inability to raise finance elsewhere? One of the attractions of a convertible to management teams is that it effectively delays issuing equity today – at what they may consider a depressed share price – in the hope of raising it at a higher share price in future.

Ultimately though, if the business needs new equity in the first place then, rather than taking the convertible bond route, might it not be better for them to bite the bullet and look to raise some new long-term equity capital, put that into the business and be done with it?

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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