Convertible Bonds: Pros And Cons For Companies And Investors

There are pros and cons to the use of convertible bonds as a means of
financing by corporations. One of several advantages of this delayed
method of equity financing is a delayed dilution of common stock and
earnings per share (EPS). Another is that the company is able to offer
the bond at a lower coupon rate - less than it would have to pay on a
straight bond. The rule usually is that the more valuable the
conversion feature, the lower the yield that must be offered to sell
the issue; the conversion feature is a sweetener. Read on to find out
how corporations take advantage of convertible bonds and what this
means for the investors who buy them.

*Tutorial:* Advanced Bond Concepts
Advantages of Debt Financing
Regardless of how profitable the company is, convertible bondholders
receive only a fixed, limited income until conversion. This is an
advantage for the company because more of the operating income is
available for the common stockholders. The company only has to share
operating income with the newly converted shareholders if it does
well. Typically, bondholders are not entitled to vote for directors;
voting control is in the hands of the common stockholders.

Thus, when a company is considering alternative means of financing, if
the existing management group is concerned about losing voting control
of the business, then selling convertible bonds will provide an
advantage, although perhaps only temporarily, over financing with
common stock. In addition, bond interest is a deductible expense for
the issuing company, so for a company in the 30% tax bracket, the
federal government in effect pays 30% of the interest charges on debt.
Thus, bonds have advantages over common and preferred stock to a
corporation planning to raise new capital.

What Bond Investors Should Look For
Companies with poor credit ratings often issue convertibles in order
to lower the yield necessary to sell their debt securities. The
investor should be aware that some financially weak companies will
issue convertibles just to reduce their costs of financing, with no
intention of the issue ever being converted. As a general rule, the
stronger the company, the lower the preferred yield relative to its
bond yield.

There are also corporations with weak credit ratings that
also have great potential for growth. Such companies will be able to
sell convertible debt issues at a near-normal cost, not because of the
quality of the bond but because of the attractiveness of the
conversion feature for this "growth" stock. When money is tight and
stock prices are growing, even very credit-worthy companies will issue
convertible securities in an effort to reduce their cost of obtaining
scarce capital. Most issuers hope that if the price of their stocks
rise, the bonds will be converted to common stock at a price that is
higher than the current common stock price. By this logic, the
convertible bond allows the issuer to sell common stock indirectly at
a price higher than the current price. From the buyer's perspective,
the convertible bond is attractive because it offers the opportunity
to obtain the potentially large return associated with stocks, but
with the safety of a bond.

There are some disadvantages for convertible bond issuers, too. One is
that financing with convertible securities runs the risk of diluting
not only the EPS of the company's common stock, but also the control
of the company. If a large part of the issue is purchased by one
buyer, typically an investment banker or insurance company, conversion
may shift the voting control of the company away from its original
owners and toward the converters. This potential is not a significant
problem for large companies with millions of stockholders, but it is a
very real consideration for smaller companies, or those that have just
gone public.

Many of the other disadvantages are similar to the disadvantages of
using straight debt in general*.* To the corporation, convertible
bonds entail significantly more risk of bank­ruptcy than preferred or
common stocks. Furthermore, the shorter the maturity, the greater the
risk. Finally, note that the use of fixed-income securities magnifies
losses to the common stockholders whenever sales and earnings decline;
this is the unfavorable aspect of financial leverage.

The indenture provisions (restrictive covenants) on a convertible bond
are generally much more stringent than they are either in a short-term
credit agreement or for common or preferred stock. Hence, the company
may be subject to much more disturbing and crip­pling restrictions
under a long-term debt arrangement than would be the case if it had
borrowed on a short-term basis, or if it had issued common or
preferred stock.

Finally, heavy use of debt will adversely affect a company's ability
to finance operations in times of economic stress. As a company's
fortunes deteriorate, it will experience great difficulties in raising
capital. Furthermore, in such times investors are increasingly
concerned with the security of their investments, and they may refuse
to advance funds to the company except on the basis of well­-secured
loans. A company that finances with convertible debt during good times
to the point where its debt/assets ratio is at the upper limits for
its industry simply may not be able to get financing at all during
times of stress. Thus, corporate treasurers like to maintain some
"reserve borrowing capacity". This restrains their use of debt
financing during normal times.

Why Companies Issue Convertible Debt
The decision to issue new equity, convertible and fixed-income
securities to raise capital funds is governed by a number of factors.
One is the availability of internally generated funds relative to
total financing needs. Such availability, in turn, is a function of a
company's profitability and dividend policy.

Another key factor is the current market price of the company's stock,
which determines the cost of equity financing. Further, the cost of
alternative external sources of funds (i.e., interest rates) is of
critical importance. The cost of borrowed funds, relative to equity
funds, is significantly lowered by the deductibility of interest
payments (but not of dividends) for federal income tax purposes.
In addition, different investors have different risk-return tradeoff
preferences. In order to appeal to the broadest possible market,
corporations must offer securities that interest as many different
investors as possible. Also, different types of securities are most
appropriate at different points in time.

Used wisely, a policy of selling differentiated securities (including
convertible bonds) to take advantage of market conditions can lower a
company's overall cost of capital below what it would be if it issued
only one class of debt and common stock. However, there are pros and
cons to the use of convertible bonds for financing; investors should
consider what the issue means from a corporate standpoint before
buying in.

*by Richard Cloutier*
Richard Cloutier, Jr., CFA, is currently the director of research and
a portfolio manager with Heritage Capital Management Inc.
Source: Investopedia.Com