Convertible bonds give the holder an option to convert his bonds into the shares of an issuer (the Issuer), or in some cases its parent, at a preset conversion price during a preset conversion period.
Generally issuers are companies as the most commonly used conversion right is that into shares of a company. The bonds may also be exchanged for shares of another company, other than the Issuer, in which case the bonds are generally referred to as exchangeable bonds.
However in both cases the same basic principles apply. Investor appetite for convertible bonds is on the increase as they allow companies to raise cheaper capital than that raised through a normal bond offering and without diluting the holdings of existing shareholders.
As convertible bonds have the benefit of a potential rise in the underlying share price of the Issuer, the yield offered is often lower than that of a normal corporate bond.
Once issued, the convertible bondholder exercises an embedded option in the conditions of the bonds by completing a conversion notice and delivering it, with the bond, to an agent of the Issuer.
The principal due on that bond is then used to subscribe for new shares in the Issuer and the existing bond is cancelled. Until conversion, the bond operates in a similar way to a straight debt instrument although, as a quasi equity instrument, it may have different tax and accounting consequences for the holder.
The price at which the conversion takes place is known as the conversion price which is, at the time of issue, usually at a premium to the market price of the shares. The terms of the bonds will also contain various adjustment mechanisms (usually by means of a reduction to the conversion price) to prevent anti-dilution and afford protection from a takeover bid. It is the conversion price which determines the number of shares issued upon conversion.
Benefits to the Issuer
The interest rate on convertible bonds is generally lower than straight bonds to reflect the underlying value to the bondholder of the conversion option.
• Certain investors will be able to treat their holding of convertible bonds as equity rather than debt. As a result, the Issuer may be able to gain access to new markets.
• If the share price of an Issuer is underperforming, the Issuer is able to gain immediate access to funding at a conversion price which is closer to what the Issuer thinks its share price should be. Once issued, if the share price is then above the conversion price, the Issuer may be able to exercise an optional redemption right. Such redemption rights are often restricted for the first
few years following issue and are generally required to be exercised at a premium.
• Once the bonds are converted into shares, the Issuer’s balance sheet becomes less geared.
Benefits to the Investor
• An investor has the relative security of receiving regular interest and, if the conversion is not exercised, principal on the bonds whilst having the opportunity to benefit from an improvement in the share price and performance of the Issuer.
• Convertible bonds tend to perform better than shares and debt when those markets are in decline. If the market value of the shares declines, the investor is unlikely to lose his entire capital.
• Because the conversion price is embedded in the convertible bond, the value of the bond also rises as the market value of the shares rise.
At the outset, it is important to analyse and understand the corporate structure of the Issuer and take into account its existing financial and contractual obligations before deciding on the optimal structure for the convertible bond issue.
The choice of structure will also depend on the jurisdiction of the Issuer and where it has its shares listed. The analysis will also involve choosing the optimal tax structure for the issue.
Particular consideration should be paid to:
• The corporate status and jurisdiction of the Issuer.
• The constitutional documents of the Issuer.
• Corporate governance principles and composition of the board of directors of the Issuer.
• The disclosure requirements of the exchange upon which the convertible bonds are to be listed.
• The listing rules of the stock exchange upon which the Issuer’s shares are listed.
A commonly used structure involves the creation of a cash box SPV (the Cashbox SPV) in an offshore jurisdiction. The Issuer issues convertible bonds to the managers of the convertible bond issue in exchange for shares in the Cashbox SPV, whose only asset is cash. The cash is supplied by the managers who subscribe for shares in the Cashbox SPV. They will recover this money from the placement of the convertible bonds with investors. Once the shares in the Cashbox SPV are transferred to the Issuer, the Issuer uses the cash in the Cashbox SPV for its own purposes — whatever the fund-raising was initially required for. This structure avoids the expense, time and statutory requirements of a pre-emptive issue. A modified cashbox structure involves the Issuer setting
up the Cashbox SPV to issue convertible bonds which are guaranteed by the Issuer. On conversion the convertible bonds become exchangeable redeemable preference shares of the Cashbox SPV. The preference shares are then immediately and automatically exchanged for ordinary shares of the Issuer. This structure has the benefits of a cash box structure as well as enabling a company short of distributable reserves to create some when the convertible bonds are converted.
• Prospectus / Offering Circular
• Subscription Agreement
• Managers Agreement
• Trust Deed
• Paying Agency Agreement
• Ancillary documents e.g. auditors’ comfort letters, board minutes, listing authority documents, legal opinions, signing and closing certificates and process agent letters
Prospectus / Offering Circular
The prospectus/offering circular includes:
• A description of the convertible bonds and their terms
• Investor protection – negative pledge, covenants,
events of default etc.
• A description of the Issuer’s business and operations.
• Financial information about the Issuer.
The information in the prospectus/offering circular must be accurate and appropriate for the type of issuer, its market position and its creditworthiness. The weaker the creditworthiness of the Issuer, the greater the amount of disclosure that will be required. The prospectus/offering circular will contain a detailed description of the business of the Issuer, more than would be the case with a straight debt offering. Because convertible bonds have equity characteristics they carry more investment risk than debt and more detailed disclosure is necessary. The particular requirements will be dictated by the legislation applicable in the jurisdiction of the Issuer and the rules of the relevant stock exchange where the convertible bonds are to be listed.
The Subscription Agreement sets out the relationship between the Issuer and the managers of the convertible bond issue. The Issuer agrees to issue the convertible bonds in the form set out in the trust deed and the managers agree to subscribe for the convertible bonds. The Issuer makes representations and provides warranties to cover the disclosure of the details of the underlying business of the Issuer. The Issuer will also agree to indemnify the managers against any loss they suffer due to any breach of those representations and warranties. The key laws regulating the offering and sale of convertible bonds and the distribution of offering material in the relevant jurisdictions affecting the convertible bonds are also set out in the Subscription Agreement.
Trust Deed and Paying Agency Agreement
The trust deed constitutes the convertible bonds and creates a trust under which the trustee agrees to hold certain property on trust for the bondholders. The Issuer covenants with the trustee to observe the terms and conditions of the convertible bonds, the key obligation being to make payments under the convertible bonds.
The trustee holds the benefit of the covenants made by the Issuer and any money it receives on trust for the bondholders. The trustee has discretion to declare events of default, to make investments, accumulate monetary sums, to call bondholder meetings and to agree minor modifications to the trust deed. The trust deed will provide for the Issuer to make payments to the trustee who, in turn, will make payments to the bondholders. However, in practice, payments to the bondholders are made through the paying agents. The trust deed will permit this payment process until an event of default has been declared at which point payments must be made direct to the trustee or to the paying agents as agent of the trustee.
The paying agency agreement also sets out the relationship between the Issuer and the paying agents and the mechanics for the payment of principal and interest under the convertible bonds to the bondholders.