Why Companies Issue Convertible Bonds - Maximizing Financing Flexibility and Minimizing Risks
Companies face a perpetual challenge of financing their growth and sustaining operations. They have two primary avenues for raising capital in the capital markets: debt and equity. Debt has the obligation to be repaid, whereas equity does not. However, the market often views companies that sell equity as overvalued and, therefore, less attractive. As a result, debt is more favorable from a capital structure perspective.
Despite this, growth-oriented companies frequently struggle to sustain high levels of debt, which is why they resort to selling equity. However, this poses a significant risk to the company's stock price, which is not favorable for the company. To balance these risks, companies opt to issue convertible bonds. These are a hybrid form of security that can be converted into equity at a predetermined conversion rate, offering growth potential while managing financial risks.
The Mechanics of Convertible Bonds
With a convertible bond, the company offers investors the opportunity to purchase stock at a predetermined price. However, the investor has the option to keep the bond and receive interest payments if the stock price does not increase. If the market price of the stock rises, the investor can convert the bond into shares of the company's equity.
The convertible bond is advantageous for both the company and the investor. For the company, it allows for raising capital while retaining potential upside, as the bondholder can convert into equity if the stock price appreciates. For the investor, the convertible bond offers both interest payments and the opportunity for capital appreciation if the stock price increases.
Advantages and Disadvantages of Convertible Bonds
Investors may choose convertible bonds for several reasons. For growth companies that are spending heavily on operations, such as acquiring customers, building facilities, or financing content, the convertible bond can be a more attractive option. In these cases, the company can use the initial cash to fuel growth, hoping that the stock price will appreciate over time, allowing the bondholders to convert into equity.
The use of convertible bonds is particularly beneficial during the early stages of a company's growth. For example, compare a scenario where a growing company like Netflix or Tesla issues a straight bond and convertible bond for the same amount. In the case of a straight bond, the company would have to pay a fixed 6% annual interest rate and repay the principal in six years, making a total of 1360 for the use of the funds.
With a convertible bond, the company pays a lower annual interest rate, such as 3.5%, and the bondholder has the option to convert the bond into equity if the stock price rises. The company may not have to pay interest for the full six years or repay the principal at maturity, hoping that the company's stock will appreciate, allowing the bondholders to convert.
For instance, if the company's stock is currently trading at $75 per share and the investor decides to hold the convertible bond, the bond may offer a conversion rate that allows the bondholder to convert the bond into shares at a lower price, such as $50 per share. If the stock price appreciates to $120 per share, the bondholder can convert the bond and gain from the stock price appreciation. In this scenario, the company would need to pay only $1210 if the stock does not rise, compared to the $1360 needed for a straight bond.
Conclusion
Issuing convertible bonds provides companies with a strategic advantage in managing their finances and navigating the complexities of capital markets. By offering a hybrid security, companies can tap into the equity market while maintaining control and potentially avoiding the risk of a stock price decline. For investors, convertible bonds represent a balanced investment opportunity, providing both interest income and the potential for equity appreciation.
Understanding the mechanics and benefits of convertible bonds can help both companies and investors make informed decisions in their capital raising and investment strategies. As the markets continue to evolve, the use of convertible bonds is likely to remain a popular and effective financial instrument for growth-oriented companies.
Key Takeaways:
Convertible bonds offer a strategic balance between debt and equity financing. They allow companies to manage their capital structure while minimizing risks. Investors benefit from both interest income and potential capital appreciation.To learn more about capital market strategies and financial instruments, visit Google's financial resources.