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The Case for Convertibles

The Case for Convertibles - Brennan The Case for...

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Brennan “The Case for Convertibles” The convertible security o In efficient markets, there should be no convincing reason in favour of convertibles o Why would investors pay more for these securities in combination than for separate offerings of straight debt and straight equity? o answer” → carry a coupon rate below market rates of interest of straight debt and allow companies to sell stock at a premium over the current price o However, no free lunch as the real economic cost of convertibles to the issuing company is not reflected by the explicit interest rate o Real cost of a convertible bond is considerably higher than the coupon rate and because of the conversion rights → also higher than the normal borrowing rate o Due to the hybrid nature → cost of convertible debt is best thought of as the weighted average of the explicit interest rate charges and the implicit opportunity costs associated with the conversion or equity option A new explanation o Widespread use of convertibles due to the relative insensitivity of their value to the risk of the issuing company o Insensitivity makes it easier for the bond issuer and the purchaser to agree on the value of the bond even when they disagree on the risk of the company o Also protects bondholders against the adverse consequences of management policies which would increase the risk of the firm o Market assign a premium for additional uncertainty → if a company is unable to assure investors about the level and stability of the risks, it may be forced to bear higher interest cost than commensurate with the actual risks o Advantage of well-designed convertible is that value is not affected by changes in the company’s risk o Evidence suggests that companies issuing convertibles are one for which uncertainty about risk is highest and cost of straight debt is prohibitively expensive (→ no reason for large, mature companies) The call question o Call provision takes on a lot of importance due to holders’ right to convert into common stock o Should be called as soon as the conversion price exceeds the call price, while providing enough of a margin to ensure conversion o Actual
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