The hybrid tool for raising funds - Convertible bonds became a very popular tool in 2020

Since August, 2020, Israeli tech firms Wix, Nice, SolarEdge, and Nova have raised $2 billion in convertible bonds. All did so at zero interest, with the bonds convertible in five years. The companies are receiving a loan for free and in five years, depending on the state of the stock and the preferences of the investors, the debt will be returned or converted to stock.

What is a Convertible Bond?

A convertible bond is a type of debt security that provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond’s lifetime. It is a hybrid security that possesses features of both debt and equity.

Similar to regular bonds, a convertible bond comes with a maturity date and pays interest to investors. In addition, if an investor decides not to convert their bonds to equity, they will receive the bond’s face value at the maturity. However, if an investor converts the bonds to the company’s shares, the bond will lose all its debt features and then possess only equity features.

Companies with a low credit rating and high growth potential often issue convertible bonds. For financing purposes, the bonds offer more flexibility than regular bonds. They may be more attractive to investors since convertible bonds provide growth potential through future capital appreciation of the stock price.

Traditionally, it is a tool used in a time of crisis

Convertible bonds were born out of the need to bridge between the gaps in interest sometimes created between the company raising funds and the investors. The companies that didn't want to, or couldn't, pay the high coupon that the investors wanted, gave them a gift - a call option.

In 2001 when shares of tech companies were at a low and they needed money. Convertible bonds fulfilled that need by preventing the dilution of investors at a low price. On the other hand, investors were willing to risk purchasing them as they provided a floor for the investment, which was the price of the stock at the time. Convertible bonds originally come from the world of funding for early-stage private tech companies in need of money when seed and angel investors still can't quite determine the value of the startups.

In the current situation tech shares have surged by tens and even hundreds of percent. Wix and Fiverr, for example, have jumped by 125% and 660% respectively. In theory, this creates a classic opportunity to raise funds by selling regular shares. However, If a company is not willing to dilute its stock shares in the short or medium term but is comfortable doing so in the long term, convertible bond financing is more appropriate than equity financing. The current company’s shareholders retain their voting power and they may benefit from the capital appreciation of its stock price in the future.

One of the advantages of convertible bonds for companies is that a deal can be done quickly - within two weeks - doesn't require a debt rating, and unlike regular debt raising, there are no financial covenants. Companies should raise funds when they can, even though there is nothing currently in the pipeline, opportunities for M&A may arise in the future, but the stock market could cool down.

Let's take an example in order to understand the mechanism of Convertible Bonds:

Example

Tesla, the electric vehicle company, issued in May 2019 a 2% Convertible Senior Note that matures in 2024. Tesla’s stock price at the time was $244 per share. The conversion rate at issuance was 3.2276 shares of common stock per $1,000 par value of the bond.

The conversion value for Tesla’s convertible issue in May 2019 was $787.53. The conversion value is calculated by multiplying the 3.2276 conversion rate by the $244 stock price.

The conversion premium when the bond was issued was $212.47. The conversion premium is calculated by subtracting $787.53 conversion value from the $1,000 par value.

The conversion premium expressed as a percentage is 27%, which is calculated by dividing the $212.47 conversion premium by the $787.53 conversion value. At the time of issuance, Tesla’s stock price would need to increase by 27% for bondholders to break even when exchanging the bonds into stock.

By late 2019, Tesla’s stock price had risen to a level that it was profitable for investors to make the conversion. Since then, Tesla’s stock price has skyrocketed so that the convertible’s market price is significantly above the bond’s investment value and closely tied to the performance of Tesla’s common stock. The convertible’s delta is close to 1.

Source:

1. Calcalist - https://bit.ly/2N5qlPq

2. CFI - https://bit.ly/2N8I1K9

3. Money for the rest of US - https://bit.ly/3aPRbDi

Picture: https://accountlearning.com/