Why Do Firms Issue Convertible Debt?
Convertible debt—convertible bonds and convertible preferred stocks--gives its owners the right to convert it into shares of common stock under certain conditions.
When a corporation is looking to raise capital, it hires an investment bank to advise it on the best way to proceed. The banker puts together the best deal for the corporation and potential buyers--institutional investors. Under certain circumstances, issuing convertible debt would be the best deal. There are several potential advantages to a corporation in issuing convertible debt.
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Interest Expense Savings
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A corporation can pay a lower interest (or dividends) in exchange for the conversion right, i.e. a “sweetener.” The conversion price is always set above the current stock price, so the “sweetener” may in effect be viewed as pre-selling the stock at a price that is above market value.
Maintain Current Stock Price
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A secondary stock offering usually causes the current stock price to fall. Debt usually cannot be converted into stock for a number of years, plus not all convertible debt holders exercise the conversion privilege all at once. So the effect of conversion, as well as of issuing convertible debt, is usually negligible compared to a secondary stock offering.
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Avoid Immediate Dilution
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Issuing more stock dilutes current earnings per share, which makes common stock less attractive to investors. Conversion over time smooths out the effect of dilution as future earnings increases may dampen the dilution effect.
Reduce or Eliminate Interest Payments and Improve the Balance Sheet
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When debt is converted into stock, the company no longer has to pay interest, and its balance sheet improves as the amount of debt as a percentage of total capitalization is reduced.
Tricks of the Trade
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Although never listed as an “official” advantage, one consideration may be very important. Since the conversion price is always set above the current stock price (issuing convertible debt instead would defeat the purpose since debt holders would immediately convert), a corporation, especially in a cyclical industry, can issue convertible debt when its stock price is at or close to a multi-year high.
Investors in a “hot” stock, caught up in the euphoria, can only see higher prices ahead and are willing to pay up for every opportunity to get their hands on more stock. By issuing a convertible bond or convertible preferred stock at that time, a corporation may bet that the stock price will never reach the conversion level, and get away with paying a lower interest for a conversion privilege that will never be exercised.
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