A convertible note is a debt instrument which grants the bondholder the right to convert the debt obligation into a predetermined number of shares of common or other stock of the issuer. They are traditionally offered by lenders requiring a higher yield, such as hedge funds and mezzanine investment firms, who are also seeking access to stock which is relatively illiquid in preference to the repayment of principal.
The number of shares that the bondholder receives upon conversion is called the “Conversion Ratio”. The Conversion Ratio may be fixed or vary over the life of the note in addition to other covenants.
Convertible bonds usually have a coupon attached that will give the bondholder the right to a coupon payment at a series of predetermined dates until maturity or forced conversion. In comparison to traditional debt the coupon rate is the same as interest rate. The frequency of the coupon payments are usually either
However, the actual coupon payment can be structured with either a fixed or a floating coupon rate and thus pay a fixed or floating coupon payment. A fixed coupon is the equivalent of a fixed income up until maturity or the time of forced conversion. However, a floating rate note can be structured and calculated in an array of different ways, primarily depending on the domicile of issue.
In the Eurobond market, most floating rate issues are denominated in US dollars. The coupon payment on a Eurodollar floating rate convertible bond is stated as a spread over the London Interbank Offer Rate (LIBOR), or the arithmetic average of LIBOR and the London Interbank Bid Rate (LIBID), referred to as LIMEAN.
Other Interbank Offer Rates that are commonly used include
- ERIBOR – Euro Interbank Offer Rate
- TIBOR – Tokyo Interbank Offer Rate
- STIBOR – Stockholm Interbank Offer Rate
- BBSY – Bank Bill Swap Bid Rate (Australia)
Many issues have got either a minimum coupon rate, maximum coupon rate or both. The min, max or combination of the two is commonly referred to as a floor, cap and collar.
Companies that issue convertible notes usually aim to minimise their weighted average cost of capital (WACC) and also attempt to stay clear of tight covenants that are usually imposed by banks in their term sheets as a prerequisite for bank debt financing. They are traditionally offered by lenders requiring a higher yield, such as hedge funds and mezzanine investment firms who are also seeking access to stock which is relatively illiquid in preference to the repayment of principal.
Convertible issues are callable by the issuer and the issuer will set the conversion price to a level that they deem acceptable. This is an important feature, because companies that are seeking additional capital funding and prefer to raise equity, but deem the current share price too undervalued can use a convertible note and force conversion when the share price reaches a predetermined level that they deem acceptable to all equity investors.
Macquarie Bank is active in several sectors including resources and infrastructure (project finance, mining, oil & gas, etc) and has more information about capital notes, company options, convertible bonds, convertible notes, convertible and converting preference shares, exchangeable bonds and notes, income securities, preference shares, PRIDES, and zero coupon bonds on their website
Macquarie Bank Website
Financial modelling implications
The issuance of a convertible bond increases the company’s cash balance (Assets), and in order to have a balancing balance sheet, this will have to be offset by either increased Liabilities or Equity. Effectively, up until either maturity or forced conversion, the note is put on as a Liability and later replaced by Equity at conversion.