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Convertible Securities and Innovation
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)
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 convertibleFrom 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 obligationAs 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)
Overview (cont.)By contrast, mandatorily converting convertibles (mandatory convertible), from a credit rating agency perspective, are considered to have equity-type characteristicsThis 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
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
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