Convertible bonds: pros and cons for companies and investors

There are pros and cons to using convertible bonds as a means of financing for companies. One of the several advantages of this equity financing method is the delayed dilution of common stock and earnings per share (EPS).

Another reason is that the company can issue bonds at a lower coupon rate—lower than the ordinary bonds it has to pay. The rule is usually that the more valuable the conversion function, the lower the yield that must be provided to sell the bond; the conversion function is a sweetener. Read on to learn how companies use convertible bonds and what this means for investors who buy them.

Advantages of convertible debt financing

Regardless of the company’s profitability, holders of convertible bonds can only receive a fixed, limited income before conversion. This is an advantage for the company because more operating income is available to common shareholders. If the company performs well, it only needs to share operating income with newly converted shareholders. Generally, bondholders do not have the right to vote for directors; voting power is in the hands of ordinary shareholders.

Therefore, when a company is considering alternative financing methods, if the existing management team is concerned about losing voting control of the business, then the sale of convertible bonds will provide an advantage over ordinary equity financing, although it may only be temporary. In addition, bond interest is a deductible expense for the issuing company, so for a company with a tax rate of 30%, the federal government actually pays 30% of the debt interest expense.

In this way, bonds have an advantage over common stock and preferred stock for companies planning to raise new capital.

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What investors should look for in convertible bonds

Companies with poor credit ratings often issue convertible bonds to reduce the yield required to sell their debt securities. Investors should be aware that some companies with poor financial status will issue convertible bonds just to reduce financing costs and have no intention of converting the bonds. Generally speaking, the stronger the company, the lower the preferred yield relative to its bond yield.

There are also companies with weaker credit ratings that have great growth potential. These companies will be able to issue convertible bonds at near-normal costs, not because of the quality of the bonds, but because the conversion function of this “growth” stock is attractive.

When funds are tight and stock prices rise, even very reputable companies will issue convertible securities to reduce the cost of obtaining scarce funds. Most issuers hope that if their stock prices rise, the bonds will be converted into common stock at a price higher than the current common stock price.

According to this logic, convertible bonds allow the issuer to indirectly sell common stock at a price higher than the current price. From the buyer’s point of view, convertible bonds are attractive because they provide opportunities for potentially huge returns related to stocks, but have the security of bonds.

Disadvantages of convertible bonds

Issuers of convertible bonds also have some disadvantages. First, financing with convertible securities not only risks diluting the company’s common stock earnings per share, but also diluting the company’s control rights. If a large portion of the issuance is purchased by a buyer, usually an investment banker or insurance company, the conversion may transfer the voting control of the company from its original owner to the converter.

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For large companies with millions of shareholders, this potential is not a big problem, but for small companies or companies that have just gone public, it is a very realistic consideration.

Many other disadvantages are similar to those of the general use of direct debt. For companies, convertible bonds carry a greater risk of bankruptcy than preferred stock or common stock. In addition, the shorter the period, the greater the risk. Finally, please note that the use of fixed-income securities will magnify the losses of common shareholders whenever sales and earnings decline; this is the downside of financial leverage.

The contractual terms of convertible bonds (restrictive covenants) are usually much stricter than short-term credit agreements or common stock or preferred stock. Therefore, the company may be more disturbing and severely restricted under long-term debt arrangements than short-term borrowing or the issuance of common stock or preferred stock.

Finally, the heavy use of debt will adversely affect the company’s ability to finance operations during times of economic stress. As the company’s fortunes deteriorate, raising funds will encounter great difficulties. In addition, in this case, investors are increasingly concerned about the safety of their investments, and they may refuse to advance funds to the company unless it is on the basis of a well-guaranteed loan. A company that uses convertible debt to finance its debt-to-assets ratio at the industry’s upper limit in a boom period may not be able to obtain financing at all in a stressful period. Therefore, corporate treasurers like to maintain a certain “reserve borrowing capacity.” This limits their use of debt financing during normal periods.

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Why companies issue convertible bonds

The decision to issue new stocks, convertible and fixed-income securities to raise capital is influenced by many factors. One is the availability of internally generated funds relative to total financing needs. In turn, this availability is a function of the 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. In addition, the cost of substituting external sources of funding (i.e. interest rates) is crucial. Compared with stock funds, the cost of borrowing funds is significantly lower due to the deduction of interest payments (but not dividends) for federal income tax purposes.

In addition, different investors have different risk-return trade-off preferences. In order to attract the widest possible market, the company must provide as many securities of interest to different investors as possible. In addition, different types of securities are most suitable at different points in time.

Bottom line

Used wisely, the policy of selling differentiated securities (including convertible bonds) to take advantage of market conditions can reduce the company’s overall cost of capital to less than the cost of issuing only one type of debt and common stock. However, using convertible bonds for financing has pros and cons; investors should consider the implications of this issue from the perspective of the company before buying.

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