The recent disruption in debt markets — better described as a tectonic shift in benchmark rates and widening corporate spreads — created sticker-shock for would be issuers. In a little over a month, corporate borrowing rates expanded anywhere from 100 to 200 basis points across the quality spectrum and even more so for truly speculative issuers. Banks are scrambling to offer issuers alternatives, and convertible debt is emerging as one of the “go to” solutions.
Convertible securities have been around in one form or another for many years. While elements of their structure have evolved, their core value proposition remains unchanged — namely, convertible securities enable companies to buy down their borrowing costs by offering investors the right to convert their debt into equity at a premium to the market price of the stock.
Why are financing alternatives suddenly back in vogue? Current market dynamics of higher rates and volatility is one. Volatility is a key factor in convertible valuation — all else being equal, the higher the volatility, the more valuable the conversion option, and the more companies can lower their coupon rate. Second, stocks are trading at or near historical highs. The renewed popularity of convertibles, however, has been accompanied by the usual misconceptions and old wives’ tales. At best, these myths cloud, impair and misdirect the corporate decision-making process; at worse they result in poor financing decisions. It’s time to debunk them.
1) Convertible bonds are too complex. Without question, convertible securities involve the interplay of more moving parts than straight debt. Depending on the settlement structure of the security and other variables, this can manifest itself in greater accounting complexity, which stems primarily from GAAP vs. adjusted EPS reporting. However, these additional complexities are manageable and should not serve as an impediment to issuance. Capital markets advisers are available to work directly with companies, independent of investment banks, to educate management teams and boards on the different structural variants and issues. Then they can help actively and cost effectively manage the transaction.
On the accounting side, all of the major accounting firms are well-versed in the various forms of convertible debt and how to accurately account for them, making the process quite manageable. Additionally, given the frequency which convertible securities are issued by public companies, equity analysts are equally well versed in understanding financial reports that include the product. So while there is no debating the fact convertible debt is incrementally more complex than straight debt, the availability of professional assistance and the securities’ compelling cost-benefit profile, particularly in a rising-rate environment, make consideration of an alternative worth the effort.
2) Convertibles invite short sellers. Given their hybrid debt and equity DNA, convertible securities lend themselves to the quantitatively oriented, risk-mitigating nature of hedge funds. While a number of dedicated institutional investors buy convertible securities, an equally large group of convertible arbitrage hedge funds focus on the product. A key facet of an arbitrageur’s investment strategy involves shorting stock against its convertible positions, but it is a common misconception that arbitrage buyers do so with the same negative bias as a conventional short seller. Convertible hedge buyers sell stock short as a means of risk mitigation — to “hedge” a portion of the “long” exposure they have through their convertible securities. They do not do so because they have a fundamentally negative view on the company’s valuation.