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.
In fact, the nature of the convertible arbitrage trading strategy makes hedge funds a natural buyer of the stock if it moves lower (because their convertible position becomes less sensitive to price movements in the equity) and their greatest returns are realized in a rising stock scenario, of which they are fundamentally supportive.
Most short selling occurs around issuance as “core” positions are established, with just small adjustments made to these long convertible/short equity positions as the stock rises or falls. In the world of short sellers, not all are the same. And short selling associated with convertible arbitrage is used to adjust position exposure, not to place a negative bet on the underlying equity.
3) Only distressed companies issue convertibles. The flexibility convertibles offer by trading equity optionality for lower coupon rates and less-restrictive covenants makes them a solution of choice for distressed companies. But the notion that only distressed companies issue them is absurd. Management teams at the likes of Microsoft, Intel, MetLife, IBM, Tesla, Wells Fargo and a host of other outstanding companies can attest to this. Those companies have access to every financial product the markets have to offer, but they have found convertible securities a highly cost-effective source of capital and, in some cases, have used the product time and again.
For troubled companies, the ability to use stock optionality as a form of compensation when the interest rates required by lenders are too onerous and unworkable, makes convertible debt a viable and, in some cases, the only solution. In fact, for a distressed company, the combined debt and equity structure of the product may be the organization’s only means of providing investors the returns they require to make a high-risk loan. The equity component, as mentioned previously, may also be hedged, providing investors an additional opportunity for risk mitigation. But these same product dynamics — the ability to utilize out-of the-money equity option value to reduce fixed borrowing costs — also enables good companies to realize extraordinarily low coupon rates with few covenants or constraints.
4) Convertibles cap a stock’s upside. At the time of placement, a convertible security’s strike or conversion price is fixed. This is an actual stock price – hard coded in the final offering documents – determined by the premium at which the convertible is “struck” over the spot price of the underlying equity. Dividing the conversion price into the principal amount of the securities determines the total number of shares the offering is convertible into. Concern is often voiced that this price represents a barrier or ceiling of sorts through which the stock will have difficulty moving, intimidating investors, discouraging buyers and creating angst among analysts.
This is simply wrong. The dissemination of shares underlying a convertible issuance is not dissimilar from that of an equity issuance – except when a convertible arbitrage fund is the buyer As outlined above, these investors will hedge a portion of their equity exposure in and around the time of issuance and, once sold, these shares no longer represent an overhang on the stock price.
Convertibles sold to fundamental investors, however, will be held until the stock has reached its respective price target or they believe the potential for further appreciation has grown limited. The convertible securities will then be sold to either another outright buyer, in which case no shares will be sold in the market, or to a hedge fund investor, which will sell some equity at the then current market price to add to its long convertible/short stock position. The timing of when additional shares underlying the convertible bond hit the market is, therefore, driven entirely by investor criteria, not the structure of the security itself.
Meanwhile, the conversion price, other than being used to determine the number of shares the transaction is tied to the value of, plays no roll whatsoever in how and when these shares are sold into the market. Because of this, and despite myths to the contrary, no well-informed analyst considers the conversion price “cap” a risk factor or rationale for assigning a lower target price to a stock.
5) Equity investors hate convertible securities. Equity investors who push back on convertible issuance by companies they hold positions in generally do so based on either a lack of product understanding or simple reflexive resistance to anything dilutive. In fact, larger, knowledgeable investors who have the ability to own both equity and debt products often participate in convertible offerings to maintain their overall ownership position. If they choose to pass on a given transaction, it may because they don’t view the terms as favorable enough to them.
Real investor backlash to a cost-effective capital raise is both rare and misguided. And in cases where such pushback does occur, it is likely a function of deeper underlying issues unrelated to the securities being issued. Generally speaking, equity investors in a company will be supportive of intelligent, cost-effective corporate financing decisions made by its management team.
If you are corporate issuer and your bank suggests convertible financing as an alternative to high yield, don’t dismiss the idea based on any of these common myths and misconceptions. Convertibles have been around for decades and successfully utilized by companies both large and small. Most issuers are very healthy and have an array of financing options at their disposal. They arrived at a convertible solution not as a last resort, but because they deemed it more efficient and cost effective than the alternatives.
Yes, distressed companies use convertibles securities, but they do so because capital structure position and stock optionality may be the only currency they have to offer. And while convertible securities do entail a greater level of complexity than other financing instruments, experienced, independent advisory and consulting professionals can help management teams confidently climb the learning curve to ensure proper terms and a well-priced, well-structured transaction.
Jonathan Cunningham is a principal at Aequitas Advisors, a capital markets advisory firm. He has more than 25 years of experience in institutional sales and capital markets origination and execution, and was most recently head of convertible securities and a member of the executive committee at Jefferies. David Pritchard contributed to this article.