sarwesh

Convertible bonds offer corporations a third way to raise new
capital, giving investors a moderate current income in exchange
for the opportunity to participate in a potential rising stock value
by converting the bond instrument into company shares using
essentially an embedded call option.


CONVERTIBLE BONDS AND THE OUTRIGHT MARKET


Corporations needing new capital may choose from an extraordinarily wide
variety of instruments that have been built and marketed by investment
banks. But, at a very basic level, they face two choices:

1. Issue more equity, which further dilutes earnings per share but has low
current financing costs.

2. Issue more straight debt, which, whereas not dilutive, may have high current
financing costs, depending upon interest rates and the company’s
credit rating.


However, there is a third choice that is a hybrid of the above two: Issue
convertible bonds.

Convertibles typically offer the instrument purchaser (bondholder) a
moderate current income with lower current financing costs (coupons) than
the company could typically offer for its straight debt. The buyer receives
lower current income (versus straight debt) in exchange for the potential of
participating in the equity upside of the company by converting the instrument
into some agreed-upon number of the company’s common equity
shares at some agreed-upon future price.
This potential for equity participation comes essentially in the form of an
embedded call option within the convertible instrument. The buyer pays option
“premium” in the form of accepting the lower coupons and/or paying an out-



right bond premium in excess of the investment value of substitutable straight
debt. In the event that the company’s future share price rises, the convertible
instrument might also rise, going “in the money,” sometimes resulting in the
buyer converting the bond into shares of the underlying company—in other
words, “exercising the conversion option.” The conversion event would then,
of course, be dilutive to the company’s earnings. On the other hand, in the
event that the share price does not rise, the company will not suffer a dilutive
event, and it may even get the chance to “call in” or redeem the issue and refinance
the bond more cheaply if interest rates decline in the future.
Like the regular equity and fixed-income markets, convertible instruments
have supply- and demand-driven equilibrium growth rates and size
constraints at any moment in time. Changing economic conditions may
induce or dissuade corporations to issue new convertible instruments versus
equity or straight debt, and corporate issuers of convertible instruments
may find it economically prudent to retire certain instruments from time to
time. Additionally, the general fortunes of the fixed-income and equity markets
will affect the convertible market capitalization by causing prices of convertible
bonds already issued to rise and fall. Very often, convertible issuance
is driven by merger activity in that the capital raised from the issuance allows
companies to pursue their acquisition strategies. Together, these effects
imply that the market capitalization of the convertible bond sector will ebb
and flow rather than rise indefinitely.
Both outright buyers and arbitrageurs must take these shifting capital
flows into account. Importantly, the composition characteristics of the
issuance will vary over time by credit quality (for example, investment grade,
high-yield, junk), concentration in sectors (for example, telecommunications,
biotechnology, financial), and so on.

The degree to which the market’s composition can change and the speed
at which it can change was illustrated in the U.S market in the first half of
2000. By May, new issuance had proceeded at a record clip of more than
$30 billion for the year to date, but technology/media/telecom (TMT) companies
had issued 68 percent of this amount, and biotech (Bio) companies
had issued 17 percent! The new issuance had come on top of existing
issuance that was already heavily skewed in these sectors, bringing the total
TMT/Bio percentage from about 56 percent of the market to about 66 percent
from January through May 2000—well above its average of around 20
percent during the 1990s.

As companies within both of these sectors tend to have high cash
requirements, raising capital via convertibles made sense. However, due to
their rapid use of cash (or “burn rates”), their credit quality tends to be lower
than for other sectors and, in many cases, these companies are practically
startups with little operating history and no credit rating whatsoever.