Pros and Cons for Companies and Investors

There are advantages and disadvantages to using corporate convertibles as funding. One of the many advantages of this equity financing method is the delay in dilution of common stock and earnings per share (EPS).

Another is that companies may offer bonds with lower coupons – less than what you would pay directly on the bonds. As a general rule, the higher the value of the conversion function, the lower the yield that will be offered on the issue sale; The conversion function is sweetener. Read on to learn how convertibles benefit the company and what it means for investors who buy them.

Advantages of leverage in convertible bonds
No matter how profitable a company is, convertible bondholders receive only fixed and limited income until conversion. This is an advantage for the company as it provides more operating income to the common stockholders. Only when it is performing well should the company share its operating income with the newly converted shareholders. Bondholders generally do not have voting rights for directors; Voting control is in the hands of the common shareholders.

So, if a company is considering alternative funding routes, selling convertible bonds to fund common stock will be profitable, if only temporarily, if the current leadership group is concerned about losing control of the business. In addition, loan interest is a deductible expense for the issuing company, so for companies that fall into the 30% tax bracket, the federal government is effectively paying 30% of the interest on the loan.

Thus, bonds have an advantage over common stock and preferred stock for companies looking to raise new capital.

What investors should look out for in convertibles
Companies with poor credit ratings often issue convertibles to reduce the yield needed to sell their debt. Investors should be aware that some financially weak companies issue convertible bonds to reduce their financing costs without ever changing the issue. As a general rule, the stronger the company, the lower the preferred return compared to bond returns.

There are also companies with poor credit ratings and great growth potential. Such companies can sell convertible bonds at near-normal prices, not because of the quality of the bonds but because of the attractiveness of the conversion mechanism for those “growth” stocks.

In fact, when money is limited and stock prices rise, many credit-worthy companies will issue convertibles to reduce the cost of raising scarce capital. Most issuers expect that when the stock price rises, the bonds will be converted into common stock at a price above the current common stock price.

According to this logic, convertible bonds allow the issuer to indirectly sell common stock at a price higher than the current price. From the buyer’s point of view, convertible bonds are attractive because they offer the possibility of generating potentially high returns related to equity while at the same time securing the bonds.

Disadvantages of convertible bonds
Convertible bond issuers also have some drawbacks. First, financing with convertible securities carries the risk of damaging not only EPS common stock, but also corporate control. If the bulk of the issue is purchased by the buyer, usually an investment banker or insurance company, the conversion can transfer control of the company’s voting rights from the original owners and convertors.

This capability is not a big deal for large companies with millions of shareholders, but for small companies or those that have recently gone public, it is a very real consideration.

Many other disadvantages are similar to the disadvantages of using direct loans in general. For a company, convertibles carry a much greater risk of bankruptcy than preferred stock or common stock. In addition, the following applies: the shorter the timeframe, the higher the risk. Finally, remember that when sales and profits decline, the use of fixed income increases the loss of common stockholders; This is a negative aspect of financial leverage.

Contract terms (restrictive contracts) for convertible bonds are usually much more stringent than short-term loan agreements or common or preferred stock. As a result, a company may be subject to very disruptive and crippling restrictions on long-term debt arrangements when borrowing short-term loans or issuing common stock or preferred stock.

In the end, the intensive use of debt will have a negative impact on the company’s ability to finance its business during times of economic crisis. With the deteriorating condition of the company, it will experience great difficulty in raising capital. Moreover, at such times, investors pay more attention to the safety of their investments and may refuse to advance company funds on the basis of well-guaranteed loans. A company funded with convertible bonds during good times, when its debt-to-asset ratio is at the highest for its industry, may not be able to get funding during stressful times. In this way, corporate cashiers prefer to retain some “reserve lending capacity”. This prevents them from using leverage during normal times.

Why do companies make convertible loans?
The decision to issue new shares, convertible securities, and fixed income securities to raise capital is determined by a number of factors. One is the availability of internally generated funds in relation to total financial needs. This availability, in turn, depends on the company’s profitability and dividend policy.

Another important factor is the current market value of the company’s stock, which determines the price of capital funding. In addition, the cost of alternative external sources of finance (ie interest rates) is critical. The cost of debt compared to equity funds is significantly reduced by reducing interest payments (but not dividends) for federal income tax purposes.

In addition, different investors have different preferences for the tradeoff between risk and return. To address the widest possible market, companies must offer securities that attract as many investors as possible. In addition, different types of securities are best suited at different times.

If used wisely, the policy of selling differentiated stock (including convertible stock) to take advantage of market conditions can lower a company’s total cost of capital compared to issuing only one class of debt and common stock. f) However, the use of convertible bonds for financing has advantages and disadvantages; Before investing, investors need to consider what the topic means from the company’s perspective.