What they are…
Convertibles are in a lot of ways vintage Wall Street. They are securities that can be converted into, or exchanged for, something else. Anything more than that is a function of the imagination of the issuers and the willingness to buy of potential holders.
Convertibles can be debt or preferred equity. They usually convert into common stock of the issuer, but there have been instances where they convert into common shares of another company, or into something else.. To keep things simple, I’m going to assume in what follows that the convertible is exchangeable into common stock of the issuer. I’ll say something about the unusual case of other kinds of conversion at the end.
All convertibles have these features:
–the security itself–either a preferred or a debenture (bond unsecured by company assets)
–conversion terms. These are normally expressed as the number of shares of common that the convertible can be exchanged for. For example, a $1000 bond might be exchangeable into 25 shares of common.
–conversion premium. This is the amount, in percentage terms, in excess of the current market price of the stock that you would pay for it if you held the convertible and exercised your right to convert. For the bond above, if it is trading at par (face value, $1000), you would be paying $40 a share for the stock if you acquired it by converting (this is sometimes called the conversion price). If the stock is now trading in the market at $30, the conversion premium is 33.3%.
–interest or dividend payment. In the case of the bond above, let’s say the annual interest payment is $50, or 5% of the face value of the bond
–call features. The issuer will typically have the right to “call,” or redeem the convertible at a specified price around face value, under either of two conditions:
1) at the end of a period of time, say, three years; or
2) if the stock trades above the conversion price by a specified amount, say, 25%, for a certain number of trading days.
If the issuer calls the convertible at a time when the stock is trading above $40, the better course of action for the holder is to exercise his conversion right, rather than collect the $1000 face value of the bond. This is called forced conversion of the convertible.
–put features, if any. The buyer may have the right to put the convertible back to the issuer at around par value under certain conditions.
You can consider the convertible as the sum of two parts: the fixed income instrument, plus a long-dated option to buy the stock. In fact, for many Japanese companies during the Eighties, as well as for some very small companies in the US, convertible issues have been structured as issues of bonds with detachable warrants (long-dated options). On completion of the offering, the warrants detach and begin trading separately.
A generation ago, the standard of valuation for convertibles, which I continue to think is the most sensible, consisted in comparing the conversion premium with yield pickup, which is the amount by which the yield on the convertible exceeds the yield on the issuer’s common.
If the common pays no dividend, the yield pickup on our convertible bond example would be 5% -0% =5%. If the stock is at $30, the conversion premium is 33.3%. This means it would take about seven years of collecting the bond interest payment in order to earn back the conversion premium. But if the bond is callable in three years and we think the call is likely, we have no chance to recoup the entire conversion premium. We’d be better off owning the common.
Why issue convertibles?
Most companies would prefer to issue “straight” (that is, non-convertible) stock or bonds, or borrow funds for expansion from a bank. But for smaller or early-stage companies, that may not be possible. Investors may feel that the company’s common stock or debentures (bonds not secured by assets) are just too risky. They want something extra to compensate for their risk-taking. A convertible is often the solution, because it combines two features: current income, and the possibility to exchange the security for common stock.
Who are the buyers?
I’m not sure. Certainly not me–at least not normally. The instruments just seem too expensive, and have been for many years. I think you’re better off buying the stock in almost every instance–and avoiding the issuer completely in a lot of the others. In uncertain times like these, there may be great trading opportunities in lower-quality issuers.
I think typical buyers are convertible mutual funds, whose charters compel them to invest a large portion of their assets in convertibles, and fixed income investors, who can’t buy stocks and whose only avenue to adding a little extra equity zip to their returns is through convertibles. Recently, convertible arbitrage hedge funds have also become a factor in this market.
You can create “synthetic” convertibles for just about any stock by holding both the stock and a call option. So you can imagine a portfolio consisting of S&P 500 stocks against which you trade options. But this is not a convertible portfolio. Yes, it’s true that in the early Eighties’ credit crunch even the largest US companies couldn’t issue straight equity at acceptable prices and issued convertibles instead. But those were very unusual circumstances. The companies underlying a convertible portfolio during the last twenty years have been what I described at the outset–smaller, niche companies that would have trouble issuing straight equity or debt. So the convertible universe doesn’t match up well with the S&P.
What about performance?
While individual convertibles may do well, the way I look at the numbers convertible funds on average don’t provide any more return than straight debt.
I looked at this issue very carefully some years ago when I was asked to supervise the creation and launch of a convertible fund. I was surprised to find that, even in a rising market, in which stocks outperformed bonds, convertibles did no better than fixed income. So we decided not to launch one.
Over the past ten years, the same seems to be true, although this may be more a commentary on how weak the stock market has been. The timing of returns vs. bonds may have been somewhat different, but I see the overall result as the same.
Having said that, in a time like the present, some convertibles may have done very poorly, either because of limited liquidity or worries about the viability of the issuing company. As credit markets return to normal and as economic conditions improve, these “near death” securities may do extremely well. Still, the relevant practical question is whetherthe underlying stock will do better.
Mesa Petroleum debentures convertible into General American Oil stock: In the second half of the Seventies, Mesa Petroleum, with T. Boone Pickens at the helm, attempted unsuccessfully to acquire a local rival, General American Oil (Mesa succeeded on its second try–another interesting story). Mesa, which was highly financially leveraged, was stuck with a very large amount of GAO on its balance sheet, much larger than it could afford to hold without interfering with normal operations. But if Mesa tried to sell, it risked being seen as giving up on GAO–at which time the large takeover premium in GAO would evaporate.
Mesa waited for a subsequent surge in interest in oil exploration companies to issue this convertible, which got money into Mesa, this illiquid asset effectively off the balance sheet, and a conversion premium to boot.
New World debentures convertible into shares of New World (China): This was a zero-coupon debenture issue by the Hong Kong-based company, New World Development, in the early Nineties. This was a “hot” issue at the time. The interesting aspect was not so much that there were no coupon payments but that at the time of issue, New World (China) didn’t exist!–except on paper and in the minds of the parties to the issue.
Commodity-backed bonds: In the nineteenth century, gold mining companies issued bonds that paid principal back in gold. In 1973, the French government issued the Giscard, after the then prime minister. Both interest and principal were indexed to the franc price of gold. In 1980 and again in 1985, Sunshine Mining issued silver-backed bonds. At maturity, you could have either your $1000 back or the value at that time of a specified number of ounces of silver. Starting in the late Seventies, the Mexican government began issuing Petrobonds, where you had a choice of being repaid 1000 pesos or the peso price of a specified number of barrels of oil. (Note that in all these cases, “in kind” redemption was not allowed, so one might argue that these are not true convertibles.)
Convertible preferred vs. convertible bonds
Holders of convertible bonds might be better off in a bankruptcy than holders of convertible preferred. But that’s not the main reason issuers choose one or the other.
Bond interest paid is a pre-tax expense. So the issuer can deduct this amount from its taxable income. Preferred dividends, on the other hand, are an after-tax expense, i.e., no tax deduction. So the issuer would only want to sell convertible preferred if he had no taxable income at present and didn’t anticipate having any for some time to come.
For today’s holder, there may be little tax difference between interest and dividend income, although at one time dividends paid to a corporation in the US were taxed at a very low rate. That’s no longer the case.
I have seen an unusual convertible that started out as a convertible preferred, but gave the issuer the option to convert the issue into convertible bonds after a certain period of time. I’m not sure who the issuer was, though.