As discussed in the last piece, a convertible bond (CB) is debt at issuance and through its life, until converted into shares. Conversion into shares happens if the share price is above a certain share price (“conversion price”) either at maturity or through the life of the bonds. Typically on the day the convertible bond is priced, the volume weighted average price of the shares or the closing price of the shares is taken as a base price (“reference price”). Conversion price is then calculated as (reference price x (1 + conversion premium)), where the conversion premium is typically between 10% and 30%. The number of shares per bond is fixed by dividing the denomination of the bond with the conversion price. This defines the maximum number of new shares that can be issued at any time, limiting maximum dilution for existing shareholders.
In order to see how this works, let us take a simple example:
Assumptions
Issue Amount: USD 25m
Reference price (closing price of shares): USD 100
Denomination of bonds: USD 100,000
Premium: 25%
Outputs:
Conversion price: USD 100 x (1+0.25) = USD 125
Number of shares per bond: USD 100,000 / USD 125 = 800
Maximum number of new shares: (USD 25m / USD 100,000) x 800 = 200,000
Premium attained over the prevailing share price can be quite an attraction for issuers as it means using the same number of shares, a convertible bond can raise more money for an issuer compared to straight sale of the shares at the market price.
Illustration of maximizing funds raised via CB using the example above:
Sale of shares at market price raises: USD 100 x 200,000 = USD 20m
Extra funds raised via a CB: USD 25m – USD 20m = USD 5m
With CBs, issuers have the flexibility not to pay the dividends on the underlying shares (the shares into which the bonds convert) until conversion happens. This has an impact as dividend is paid from profits after tax while any coupon on the convertible debt gets a tax shield. For small and mid cap growth companies, prudently structured and priced convertible bonds can be quite an advantage. At early stages of growth it can be useful to raise cheaper debt (vis-à-vis conventional unsecured capital markets debt) and simultaneously defer any potential equity dilution (actual dilution occurs only upon conversion) that too at a premium to the current price.
One word of caution here pertains to the size of the CB relative to free float of a company and liquidity of its shares. Upon conversion, new shares of the company come into existence. This increases free float and affects liquidity. Some investors might want to sell the shares they receive upon conversion to realize gains. If the issue size is large relative to the free float and liquidity then sale of these shares is difficult. A downward impact on the share price can be a likely outcome if discounted selling begins. A sad truth is that some Indian corporates have raised money via FCCBs such that the issue size is over 50% of free float and represents over hundreds of days of trading volumes. Such high issue volumes also put an immense pressure on the balance sheet. As the share price underperforms, the issue size ratio to market cap only increases (issue size remains constant while market cap keeps reducing), implying a huge redemption obligation for the issuer. Going forward, in my humble opinion, Indian issuers must pay heed to the issue size and not get carried away.
While we discussed benefits of CBs for issuers, for investors, the option to participate in the upside of the company’s shares via a CB is also an appealing proposition. To begin with, in convertible bond participation, principal investment is protected unlike investment into equity capital of a company (in the worst case scenario shares under perform and bonds are redeemed for cash). If the shares perform well, beyond the premium level, investors can have 100% participation in the share price performance. For companies that have transparent and stable credit, this equity option is quite cheap (circa 5% - 15% of the total CB value) and hence can prove to be lucrative for the investor community.
Taking the same example as above, let us see how the share price at maturity impacts an investor’s decision to convert into the underlying shares or redeem the bonds for cash.
Share price at maturity: USD 120
Worth of the 800 shares per bond: USD 120 x 800 = USD 96,000
Value of each bond: USD 100,000
Hence the investor opts to redeem the bonds in cash as economically he is better of and gets his principal back (ignoring any interest for the time being). However, consider the following scenario:
Share price at maturity: USD 130
Worth of the 800 shares per bond: USD 130 x 800 = USD 104,000
Value of each bond: USD 100,000
In this case, the investor will want to convert into shares. If he sells the shares in the market then he gains USD 4,000 over the value of the bonds (ignoring any transaction costs and assuming share price remains constant). Thus we can see that as the share price increases, the incentive for investors to convert also increases.
Investors, whose mandates do not allow them to invest directly in equity, use convertible bonds as a proxy to get equity exposure. Equity investors like to invest in the riskier companies via convertible bonds to protect their principal. Fixed income investors look at convertibles as a yield advantage product while dedicated convertible bond investors use both the equity and debt characteristics of the product to make returns. Hence, convertible bonds are appealing to a wide ranging investor base.
Most Indian FCCBs have a high bond floor (please refer to the previous post for an explanation) and hence are more debt like. Thus, for India in particular, in the absence of sovereign international capital markets debt, FCCBs provide global investors an alternate means to get exposure to India credit.
There is large merit in the product, however, it needs to be structured and priced prudently. That will be highlighted in the next discussion piece.
In order to see how this works, let us take a simple example:
Assumptions
Issue Amount: USD 25m
Reference price (closing price of shares): USD 100
Denomination of bonds: USD 100,000
Premium: 25%
Outputs:
Conversion price: USD 100 x (1+0.25) = USD 125
Number of shares per bond: USD 100,000 / USD 125 = 800
Maximum number of new shares: (USD 25m / USD 100,000) x 800 = 200,000
Premium attained over the prevailing share price can be quite an attraction for issuers as it means using the same number of shares, a convertible bond can raise more money for an issuer compared to straight sale of the shares at the market price.
Illustration of maximizing funds raised via CB using the example above:
Sale of shares at market price raises: USD 100 x 200,000 = USD 20m
Extra funds raised via a CB: USD 25m – USD 20m = USD 5m
With CBs, issuers have the flexibility not to pay the dividends on the underlying shares (the shares into which the bonds convert) until conversion happens. This has an impact as dividend is paid from profits after tax while any coupon on the convertible debt gets a tax shield. For small and mid cap growth companies, prudently structured and priced convertible bonds can be quite an advantage. At early stages of growth it can be useful to raise cheaper debt (vis-à-vis conventional unsecured capital markets debt) and simultaneously defer any potential equity dilution (actual dilution occurs only upon conversion) that too at a premium to the current price.
One word of caution here pertains to the size of the CB relative to free float of a company and liquidity of its shares. Upon conversion, new shares of the company come into existence. This increases free float and affects liquidity. Some investors might want to sell the shares they receive upon conversion to realize gains. If the issue size is large relative to the free float and liquidity then sale of these shares is difficult. A downward impact on the share price can be a likely outcome if discounted selling begins. A sad truth is that some Indian corporates have raised money via FCCBs such that the issue size is over 50% of free float and represents over hundreds of days of trading volumes. Such high issue volumes also put an immense pressure on the balance sheet. As the share price underperforms, the issue size ratio to market cap only increases (issue size remains constant while market cap keeps reducing), implying a huge redemption obligation for the issuer. Going forward, in my humble opinion, Indian issuers must pay heed to the issue size and not get carried away.
While we discussed benefits of CBs for issuers, for investors, the option to participate in the upside of the company’s shares via a CB is also an appealing proposition. To begin with, in convertible bond participation, principal investment is protected unlike investment into equity capital of a company (in the worst case scenario shares under perform and bonds are redeemed for cash). If the shares perform well, beyond the premium level, investors can have 100% participation in the share price performance. For companies that have transparent and stable credit, this equity option is quite cheap (circa 5% - 15% of the total CB value) and hence can prove to be lucrative for the investor community.
Taking the same example as above, let us see how the share price at maturity impacts an investor’s decision to convert into the underlying shares or redeem the bonds for cash.
Share price at maturity: USD 120
Worth of the 800 shares per bond: USD 120 x 800 = USD 96,000
Value of each bond: USD 100,000
Hence the investor opts to redeem the bonds in cash as economically he is better of and gets his principal back (ignoring any interest for the time being). However, consider the following scenario:
Share price at maturity: USD 130
Worth of the 800 shares per bond: USD 130 x 800 = USD 104,000
Value of each bond: USD 100,000
In this case, the investor will want to convert into shares. If he sells the shares in the market then he gains USD 4,000 over the value of the bonds (ignoring any transaction costs and assuming share price remains constant). Thus we can see that as the share price increases, the incentive for investors to convert also increases.
Investors, whose mandates do not allow them to invest directly in equity, use convertible bonds as a proxy to get equity exposure. Equity investors like to invest in the riskier companies via convertible bonds to protect their principal. Fixed income investors look at convertibles as a yield advantage product while dedicated convertible bond investors use both the equity and debt characteristics of the product to make returns. Hence, convertible bonds are appealing to a wide ranging investor base.
Most Indian FCCBs have a high bond floor (please refer to the previous post for an explanation) and hence are more debt like. Thus, for India in particular, in the absence of sovereign international capital markets debt, FCCBs provide global investors an alternate means to get exposure to India credit.
There is large merit in the product, however, it needs to be structured and priced prudently. That will be highlighted in the next discussion piece.
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