The Effects of Convertible Bonds on Balance Sheets
A balance sheet is a summary of an entity's financial condition and is divided into assets (conventionally arranged on the left-hand side), liabilities and equities (both on the right-hand side). The immediate effect of issuing a convertible bond is to increase the liabilities of the issuer. Given the fundamental accounting formula (assets minus liabilities equals equity), this also lowers equity. When a convertible bond is converted into stock, it disappears from the liability portion of the balance sheet and re-appears as equity.
Other People Are Reading
-
Terms
-
Convertible bonds are bonds that convey to their holder the right to convert these instruments into the company's stock as a predefined ratio. The basic terms under which the bond is issued are: the yield, payment dates, maturity date, conversion ratio, call protection and dilution protection.
Protections for Convertible Holders
-
As Campbell Harvey explains in his Hypertextual Finance Glossary, in "call protection," the issuer promises that it will not buy back, or "call," the bonds within a specified period. Calls occur during periods of lowered interest rates, when companies decide to retire their old debt at the higher rates and issue new debt taking advantage of the decline. Non-callable bonds (convertible or otherwise) are thus more valuable than callable ones.
In "dilution protection," the issuer commits itself to a change in the conversion ratio in the event it issues new stock, to "avoid dilution of a convertible bondholder's potential equity position," as Harvey puts it.
-
Equity Investors
-
If you are considering making an equity investment in a company that has a lot of convertible bonds outstanding, you should consider the danger of dilution that poses for you.
When such bonds are converted, by definition there is more stock in the issuer than their had been before, and by operation of the law of supply and demand, your own stock's value will almost certainly drop. Also, the significance of the block of shares that you hold, considered as possible votes for the board of directors or for or against resolutions in a proxy contest, will be reduced.
Accounting for the Dilution
-
According to Marie Leone, who wrote about this subject for the periodical "CFO" in August 2008, "companies are required to apply the 'if-converted' method of computing diluted [earnings per share], whereby an issuer assumes that the bond will be repaid using company stock. The shares are then added to the common shares outstanding tally, and earnings are divided by the total to produce the diluted EPS."
Floating-Price Convertibles
-
Distressed companies will sometimes issue convertibles with conversion ratios that depend on the market price of the underlying equity. For example, a bond may not be convertible for two shares of stock if the price of the stock remains above $20, but convertible for two shares if it falls to or below that level.
The floating-price convertibles, FPCs, are sometimes given the scarier name "death-spiral convertibles," because when a firm is in trouble and its stock price is falling, and this fall triggers the change in the conversion ratio, that change, and the resulting conversions, push the stock price even lower.
The issuance of FPCs indicates desperation by management, and some charge that these instruments facilitate stock-price manipulation. Accordingly, most investors should avoid any company with these instruments on its balance sheet.
-
