Chapter 9-Convertible Securities and Innovation - Convertible Securities and Innovation Overview A convertible security is a type of equity offering

Chapter 9-Convertible Securities and Innovation -...

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Convertible Securities and Innovation
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Overview A convertible security is a type of equity offering, even though most convertibles are originally issued in the form of a bond or preferred shares Most convertible bonds or convertible preferred shares are convertible anytime (after a three month period following issuance), at the option of the investor, into a predetermined number of common shares of the issuer This is called an “optionally converting convertible” The other type of a convertible is a “mandatorily converting convertible”, where the investor must receive a variable number of common shares (based on a floating conversion price) at maturity (a mandatory receipt rather than an option to receive)
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Overview (cont.) The issuer’s preference regarding equity content of the convertible determines whether the convertible will be issued as an optionally converting convertible or a mandatorily converting convertible From the perspective of a credit rating agency, an optionally converting bond is considered to have bond-type characteristics since there is no assurance that the bond will convert into common shares and there is a fixed coupon payment obligation As a result, when originally issued, an optionally converting bond weakens a company’s balance sheet in almost the same way that a straight bond of the same size and maturity would (although the company’s balance sheet will subsequently be strengthened if the convertible bond eventually converts into common shares)
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Overview (cont.) By contrast, mandatorily converting convertibles (mandatory convertible), from a credit rating agency perspective, are considered to have equity-type characteristics This is because there is certainty regarding conversion into common stock (and therefore no cash repayment obligation at maturity in the event of non-conversion) Therefore, mandatory convertibles strengthen a company’s balance sheet in almost the same way that a common share offering of the same size would
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Rational for Issuing a Convertible If a company wants to issue debt, they might consider a convertible bond rather than a straight bond in order to reduce the coupon associated with debt issuance For example, if a company could issue a $100 million bond with a seven-year maturity and a coupon of 6%, that same company might be able to issue a convertible bond for the same amount and maturity, but with a coupon of 3% The reason convertible bond investors might accept a coupon that is 3% lower than a straight bond coupon is because the convertible bond gives them the option to receive a predetermined number of common shares of the issuer’s stock in lieu of receiving cash repayment
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Rationale (cont.) If the value of the common shares that convertible bond investors have the right to receive does not exceed $100 million during the life of the convertible, they will generally not elect to convert the bond into shares and will therefore receive $100 million in cash
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