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This ‘bond with a twist’ is sending a worrying message on risk

The growing willingness of convertible bond investors to trade in a ‘heads you win, tails you don’t lose’ assurance for a small uptick in yield is a worrying sign of increased risk tolerance in markets

06/11/2018

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

In the world of finance, not all investors are created equal. In fact, this is a truth largely held to be self-evident and the reason for investors’ composure on the issue largely boils down to a matter of risk versus reward.

Broadly speaking, equity investors expect to see greater returns in the longer run than their bond counterparts on average because, if things go wrong, they also stand a greater chance of losing some or all of their money.

Nor are all bond investors created equal – and, once again, this comes down to risk versus reward.

As we have discussed before in articles such as Blame it on the Schuldschein, the years since the financial crisis have seen income-hungry investors increasingly willing to sacrifice a degree of security in return for an uptick in yield – hence the rise in popularity of curious-sounding beasts such as ‘covenant-lite’ and ‘PIK-toggle’ bonds.

And now, it would appear, mandatory convertible bonds, which have been issued in recent months by global giants such as Bayer and Vodafone.

Mandatory convertible bonds...

Let's get back to basics.

What's a convertible bond?

This is a product where the holder can convert their bond into a specified number of the company's stock or equivalent cash value.

What's a mandatory convertible bond?

These are like traditional convertible bonds but with one important difference – instead of the holder getting to choose when – or importantly if - they convert their bond into a predetermined amount of the issuing company’s equity, the conversion date is set in advance by the company itself.

In return for sacrificing this ‘optionality’, mandatory convertible bondholders will generally receive a little bit of extra yield – although, in the current environment of historically low interest rates, it really is only a little bit.

It is, however, a continuation of a trend where investors accept more risk in order to eke out a few more basis points of income.

An admission of weakness 

Convertible bonds generally are issued by companies who don’t have other, more normal, sources of debt open to them. The market views the issue of a traditional convertible bond more negatively than new ordinary debt because it implies management are having to consider funding options that might dilute existing shareholders.

It is essentially an admission of weakness, to at least some degree.

With a mandatory convertible bond, however, management are acknowledging they need to issue equity and, what is more, they need to be able to tell interested parties such as banks, ratings agencies and so forth that this definitely will happen.

The possibility that it might do if bondholders want it to isn’t sufficient.

What management are less keen on is having to admit that they need to do an equity issue today to investors and so they issue a bond instead – a bond with a twist. An instrument that looks like a bond today but in, say, three years time will definitely convert into shares that will definitely dilute existing shareholders unless other actions are taken.

What we are also witnessing then is the other side of the coin – a more relaxed attitude to risk from investors.

A more relaxed attitude to risk

With a traditional convertible bond, the holder gains if the shares go up in price because they can choose to convert to equity.

And if the shares do not go up in price, the holder does not mind as they still own a bond, with the security that entails, and thus can reasonably hope to see their money back, plus interest at the end of its term.

To put it another way, that is ‘heads you win, tails you don’t lose’.

With the mandatory version, however, that conversion to equity is coming regardless of whether it suits the bondholder – the conversion may happen even if the market share price is far below the conversion price - meaning they have lost that ‘heads you win, tails you don’t lose’ assurance in return for a limited pick-up in yield compared with a traditional convertible.

And presumably the only reason you would do that as an investor is if you were confident about the future and you still thought shares prices were more likely to rise than fall.

As such, the more mandatory convertible bonds we see being issued – and issuance has picked up significantly over the last year or so – the more it says about the risk tolerance of the market.

And the more uneasy we grow, here on The Value Perspective.

 

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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