A convertible bond is a debt obligation of the issuing corporation that the holder may convert to a preset number of shares of common stock at a preset conversion price. It has both positive and negative consequences for the older stockholders.
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On the plus side, if the issuance raises money that the firm employs in a productive way, or to finance a necessary restructuring, and it does so while incurring less liability, this is of benefit for all the shareholders. As Roland Gillet and Hubert De La Brusierie wrote recently in their article, "The Consequences of Issuing Convertible Bonds," such bonds can also "issue a positive signal regarding the restructuring of the firm's financial liabilities and its attempts to optimise its financial structure."
Advantage Over Non-convertible Bonds
The advantage of convertible over non-convertible bonds as a way of raising money is simple. Issuers find that they can sell convertibles for lower yields ("coupons"). The reason for this is, precisely, that convertibles have the extra feature of the option to buy stock, and that makes them more valuable.
Advantages Over Stock
They have advantages over the direct issuance of stock, too, on both sides of the transaction. Interest payments are tax deductible for the issuer. Also, interest payments are a contractual obligation and are paid even in a cash crunch that would lead a corporation to suspend its stock dividends, so the certainty benefits buyers.
Convertibles also have another advantage over the immediate issuance of stock. They do not in their initial effect dilute the value of existing stock.
According to Aswath Damodaran, of the Stern School of Business at New York University, surveys of the corporate managers who make such decisions indicate that this is a critical consideration for them. The higher-ranked input into a capital-structure decision is, unsurprisingly, how much cash it will raise. The second-highest input is "avoiding dilution of common equity's claims." This means that non-dilution comes in ahead of such considerations as risk, restrictive covenants or taxes.
Nonetheless, convertible bonds do cause dilution -- even if it is delayed somewhat from the day of issuance. When the dilution will take place will depend upon the movements of the stock price.
A convertible bond has a conversion ratio that might be (for example) 80. This means that the one bond may be converted into 80 shares of common stock. At any given time, multiplying the conversion ratio by the underlying stock's price yields a figure known as "parity." So, if the stock is selling for £5.50, then the bond may be converted into £442 worth of stock. Parity is often expressed as a percentage of the bond's par value. If par value is £650, then parity in this instance is 68 per cent (or 68 bond points).
A rational investor will not want to convert the bond into shares until parity is at least 100 per cent. In the example, this would require a stock price of £8.10. The investor will expect dilution as the stock price crosses that point.
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