Tuesday, 27 September 2011

Anatomy of a convert - why?

Why is there a convertible asset class in the first place?  Don't we have enough variety already?  First, a very high level explanation of what a convertible bond is.  An issuing institution (a company) creates a new convertible bond  issue because first and foremost it needs money.  So in that sense a convert is like a standard corporate bond, or a bank loan.  But if you decided to loan the money to the institution, then you get an additional right, namely the right to hand in your fraction of the convertible issue in exchange for a contractually agreed number of shares - usually shares in the issuing company itself.  Notice that this is usually a 'right but not an obligation', which means that it is a kind of call option on the company's shares.  So the lender transfers a cash amount up front to the issuing institution in return for a convertible security which entitles it to many things, usually including a regular interest payment, just like a bond or a loan, the option to convert into shares, under conditions agreed up front, and the right to ask for your money back, again under certain circumstances; there are also many entitlements accruing to the issuer wrapped up in the legal package too - the right under certain circumstances to hand the money back to the lender earlier.  In short, a convertible is a bond with a bunch of additional derivatives buried in the package.

So why not just get a loan?  Why go to so much fuss, pay a bunch of investment bankers and lawyers hefty arrangement fees, potentially give part of your beloved company away in form of share options?  It all seems ridiculously, fiendishly complex.  The answer lies in the domain of corporate finance, which will be the subject of the next posting.