Keywords: convertible bonds, conversion price, fixed rate bond

INTRODUCTION

WHAT ARE CONVERTIBLE BONDS?

Convertible bonds are, customarily, fixed rate bonds issued by a company, the terms of which allow the holders of the bonds to convert them into ordinary shares of the company at a prescribed conversion price during a prescribed new conversion period.

Convertible bonds can be seen as a combination of two separate financial instruments – namely:

  • a fixed rate bond; and
  • an embedded equity call option.

This combination of features provides investors in convertible bonds with certain distinct advantages over a similar investment in plain vanilla bonds or the ordinary shares of the company. In very general terms, convertible bonds are capable of offering investors equity upside potential in the ordinary shares of the relevant company as a result of the equity call option and, at the same time, capped downside risk as a result of the fixed rate bond's coupon and ultimate return of principal on the final maturity date. This equity upside potential and capped downside risk is often termed "Optionality" by convertible bond practitioners. Exchangeable bonds are exchangeable into already issued ordinary shares of a company (other than the issuer of the exchangeable bond) at a prescribed exchange price during a prescribed exchange period.

HOW ARE CONVERTIBLE BONDS PRICED AND HOW AND WHEN DO THEY CONVERT INTO ORDINARY SHARES?

There are many technical methods of valuing convertible bonds (and, in particular, of pricing the embedded equity call option) and it is beyond the scope of this Guide to explore pricing methodologies in detail. Pricing consists of two elements, the initial conversion price and the coupon. The initial conversion price of a convertible bond is, customarily, based on the sum of (i) the volume weighted average price of the ordinary shares of the company ("VWAP") between announcement of the offering ("Launch") and the pricing of the convertible bonds ("Pricing") and (ii) a conversion premium thereto (the "Conversion Premium").

The correlation between the coupon payable on a convertible bond and the Conversion Premium is important. In summary, investors will expect to receive a correspondingly higher coupon on a convertible bond if the Conversion Premium is set at the higher end of its pricing range. Investors will, in these circumstances, expect to have to wait a longer period before the market price of the ordinary shares of the company exceeds the conversion price of their bonds, at which point it becomes economically viable for the bondholders to convert. Investors will, accordingly, treat convertible bonds with a high Conversion Premium as more "debt like" and require, as a result, a coupon more in line with that payable on a plain vanilla bond of a similar credit. Alternatively, if the Conversion Premium is set at the lower end of its pricing range, it is likely that investors may accept a correspondingly lower coupon.

Remember that the Conversion Premium reflects the value of the embedded equity call option in the convertible bond. The value of the convertible bonds is also comprised, however, of (i) the value of the bonds themselves (represented by the discounted value of the coupons and their redemption price and known as the "Bond Floor") and (ii) the value of the ordinary shares of the company underlying the convertible bonds from time to time (and known as "Parity"). These features will be discussed in more detail later on in this guide.

WHAT ARE THE BENEFITS AND DISADVANTAGES OF CONVERTIBLE BONDS TO AN ISSUER AND AN INVESTOR ALIKE?

There are a number of benefits for issuers and investors in convertible bonds. There are, of course, downsides for both parties to consider:

Benefits

Disadvantages

Issuer

  • The company receives up front payment for ordinary shares to be issued at a later date, customarily at a premium to their market price. To the extent that a company considers its ordinary shares to be undervalued at the time of pricing of the bonds, the issue of convertible bonds may be an attractive alternative to issuing ordinary shares.
  • Investors will accept a lower interest rate on convertible bonds than plain vanilla bonds, given the additional value of the equity call option – this will be helpful for a company seeking to better manage its debt service and leverage ratios.
  • If the price of the company's ordinary shares increases above the conversion price, the bonds will convert into ordinary shares and the company will not need to repay its borrowings.
  • The company is provided with access to a broader investor base, as convertible bond investors consist of both hedge funds and "long-only" equity investors.
  • The company is "forward selling" its ordinary shares through the equity call option, which, if exercised, will lead to dilution of existing shareholders' stakes in the company – this may be a sensitive area from a relationship perspective for the company and put downward pressure on the company's share price. From a legal perspective, the pre-emption right position of existing shareholders will need to be considered.
  • The ordinary shares of the company may not perform during the life of the bonds. In this case, holders of the bonds may not exercise their conversion rights and the company will be forced to pay interest on the bonds during their entire tenor and, on their final maturity date, return principal through new financing or available cash.
  • The hedging strategies of certain investors may lead to downward pressure on the company's ordinary shares, as some investors that purchase the convertible bonds may "short" the ordinary shares to hedge their respective positions.

Investor

  • Irrespective of the performance of the ordinary shares of the company, the bonds continue to provide a fixed rate of income for investors through the coupon, and a protected return of principal on their final maturity date.
  • If the company were to become insolvent or be liquidated, an investment in convertible bonds would have even rank with the company's unsecured debt and rank ahead of an investment in the ordinary shares of the company in insolvency proceedings.
  • The investor has, as mentioned above, upside participation in the performance of the ordinary shares of the company, as its option to convert its holding of the bonds into ordinary shares is set at a fixed price, and the holder of the bonds therefore benefits from any increase in the market value of the ordinary shares above that fixed conversion price.
  • If the ordinary shares of the company do not perform, the investor will have achieved a poor return on its investment (represented by the lower coupon payable on convertible bonds as against the coupon payable on plain vanilla bonds of a similar credit) as at the final maturity date. This opportunity cost may be partially offset by gains made by shorting the ordinary shares.
  • The value of convertible bonds can be eroded by corporate actions taken by the company or negative events which occur in the life of its business. Whilst customary protections are contained in the terms of convertible bonds it is not possible to protect the investor from all events which might erode the value of their convertible bonds.

CREDIT AND EQUITY PROTECTION

WHAT PROTECTIONS DO INVESTORS EXPECT IN THE TERMS OF CONVERTIBLE BONDS?

(A) Credit Protection

The convertible bond market has, conventionally, been a senior, unsecured bond market which has followed the terms of plain vanilla senior, unsecured Eurobonds in respect of the fundamental credit protections expected by investors. This might, at first, sound counter-intuitive, given many of the companies which issue convertible bonds are "cross-over credits" or non-investment grade companies. It is, however, a combination of the embedded equity call option and the types of investors in this asset class (and, in particular, hedge funds which hedge their credit exposure) which mitigates any related concerns as to the nature of the bonds' limited credit protections. Whilst the terms of each issue of convertible bonds will vary, it would be customary to find few (if any) covenants in their terms, other than a negative pledge and a series of events of default.

  1. Negative Pledge: An example of the undertaking which might appear in the terms of a convertible bond is set out on page 22 of this guide (a "Negative Pledge"). In summary, a Negative Pledge is by no means as restrictive as an "all monies" negative pledge customarily found in credit facilities. A Negative Pledge seeks only to protect the marketability of the convertible bonds in the secondary markets by ensuring that, should the company (or, if agreed, all or some only of its subsidiary companies) seek to issue in the future a secured bond or other form of secured indebtedness which is capable of being listed or traded on the same or competitive markets, the holders of the convertible bonds will be entitled to the same or a similar security package.

    Despite the inherent limitations of a Negative Pledge, the company may wish to restrict its scope to only the company itself, or a defined number of principal subsidiaries. The company may also consider tailored exceptions (including to exempt pre-existing financing arrangements).

    Any such exceptions would, of course, need to be discussed in detail with the relevant underwriting banks to assess their effect on the pricing and marketability of the convertible bonds.
  2. Events of Default: The events of default set out in the terms of a convertible bond will reflect the credit quality of the relevant company and will be broadly aligned with the events of default set out in the terms of other bonds (if any) issued by the relevant company (or similar to the events of default of other companies of similar credit standing and industry), including, amongst others, default on failure to pay, cross acceleration and insolvency. The related grace periods and other carve-outs to the Events of Default which benefit the relevant company will also closely track similar mitigation provisions found in the terms of other bonds or, if no such bonds have been issued, will be specifically structured to meet the company's business needs. A summary example of a customary package of events of default found in the terms and conditions of a convertible bond are set out on page 23 of this guide.

(B) Protecting the Equity Call Option's Value

As mentioned earlier in this Guide, investors in convertible bonds forego a higher coupon for the benefit of the equity call option. The investors have bought this equity call option, however, with a conversion price at a premium to the market price of the ordinary shares of the company. If the value of the equity call option is negatively affected subsequently by actions taken by, or events in the life of, the company, then investors will require compensation by an effective return of their Conversion Premium.

This "plays out" in practice in the terms of convertible bonds by a downward adjustment to the bonds' conversion price. As the number of ordinary shares deliverable on the exercise of conversion rights by a bondholder is determined by dividing:

  1. the principal amount of each convertible bond by
  2. the conversion price of the bond in effect immediately prior to its exercise,

the reduction in the denominator yields for an investor, on conversion, a greater number of ordinary shares per bond – thus compensating the investor for loss of value in the equity call option purchased by it, at pricing, at a premium. This compensation by means of anti-dilution provisions in the terms of convertible bonds (also known as "Adjustment Provisions") is best seen in a series of examples:

1. Mechanical Adjustments

Easiest perhaps to understand are mechanical adjustment provisions, which are triggered when the company takes corporate actions which have a "mechanical effect" on the price of an ordinary share. Let's say, for example, the market price of a company's ordinary share is HK$10.00 and, at pricing, the conversion price of its convertible bonds is set at HK$12.00 per share (i.e. at a 20% Conversion Premium). Assuming the market value of the company is stable, if the company later decides to subdivide its ordinary shares of HK$10.00 by undertaking a "stock split" at a ratio of 1:2, each existing ordinary share of HK$10.00 will now be worth HK$5.00 only and the conversion price of HK$12.00 per share will also need adjusting (halving) to protect Parity.

Summary of Formula:

If and whenever there shall be a subdivision affecting the number of Ordinary Shares, the Conversion Price shall be adjusted by multiplying the Conversion Price in force immediately prior to such subdivision by the following fraction:

A
--
B

where:

A is the aggregate number of Ordinary Shares in issue immediately before such subdivision; and
B is the aggregate number of Ordinary Shares in issue immediately after, and as a result of, such subdivision.

Other examples of mechanical Adjustment Provisions in the terms of convertible bonds include consolidation and reclassification of the company's ordinary shares and the issue of bonus shares by the company by means of capitalisation of reserves.

2. Parity Adjustments

In addition to corporate actions of the company which result in mechanical adjustments to the conversion price, a company may negatively affect Parity by distributing cash and non-cash assets of the company to existing shareholders and/or issuing further securities to other persons at an undervalue.

The company may, for example, make a rights issue of ordinary shares (i.e. a new issue of ordinary shares to shareholders pro rata) or options below the current market price of the ordinary shares (as is almost invariably the case in order to encourage shareholders to subscribe the rights).

As a result, the market price of the ordinary shares and, accordingly, Parity, will drop, because the company has not received full value for the rights. However, the holders of convertible bonds will have not been able to participate in the rights issue, unlike the existing shareholders of the company. The conversion price of the convertible bonds is, accordingly, adjusted downwards to compensate bondholders, by reference to the value of the rights that are given to shareholders.

Summary of Formula:

If and whenever the Issuer shall issue Ordinary Shares to Shareholders as a class by way of rights at a price per Ordinary Share which is less than 95% of the Current Market Price per Ordinary Share on the Effective Date, the Conversion Price shall be adjusted by multiplying the Conversion Price in force immediately prior to the Effective Date by the following fraction:

A + B
--------
A + C

where:

A is the number of Ordinary Shares in issue on the Effective Date;
B is the number of Ordinary Shares which the aggregate consideration (if any) receivable for the Ordinary Shares issued by way of rights would purchase at such Current Market Price per Ordinary Share; and
C is the number of Ordinary Shares to be issued.

Other examples of Adjustment Provisions relating to Parity relate to the making of non-cash distributions, spin-offs, share buy-backs at a premium and the payment of cash dividends. A separate section on "Dividend Adjustments" is set out below in this Guide.

To read this Guide in full, please click here.

Originally published 30 April 2014

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