Monday, 3 October 2011

Anatomy of a convert - I gave the company all my cash and all I got was this lousy security

I'd like to step back a bit.  See the commonality in what is already the beginnings of a complex jungle of security types.  Don't forget, all that's happening here is a company needs money and gets it from people or institutions which have it.  There's a distribution of cash from those who have it now to those who could use it now.  Everything else is secondary detail.  Think of the corporate loan, the straight bond, the convertible, as just exemplars of a grander swap agreement to which all specific security instantiations conform.

In its simplest, most theoretical form, the swap in question is a swap of money.  Imagine a contract in which, for some reason, I agreed to give you right now £1,000 and simultaneously you agreed to give me £1,000.  That's one of the most basic swaps.  Such a like-for-like swap contract doesn't exist, since there's no economic reason for doing it.  But, say I am exchanging £1,000 of coins into £1,000 of notes, then it might make sense.  Or perhaps I like the serial numbers on your cash (or the year of issue, or the portraits or aesthetics of the notes and coins).  I might even be prepared to pay a fee for the 1,000-for-1,000 swap.

Now, imagine it is a swap now of £1,000 for $1,530.  Assuming an FX rate of 1.53 then this has achieved some clearer economic value - I now own dollars and can make a dollar purchase.  Likewise you can quite easily imagine a whole series of increasingly complex, and contingent, swap agreements.

For example, imagine a swap as follows.  Party A gives party B £1,000 now and party B gives party A £1,100 in a year's time.  I could interpret that as a loan, couldn't I?  I could say that this is a loan for a year, with a repayment plus a single annualised interest component of £100.  A loan of £1,000 for a 1 year term with an annualised interest payment of 10%.  Another interpretation could be: this is a purchase of money-in-the-future, the cost of which is £1,000 now.

Cash flow swaps can be unconditional, or contingent on something else in the world happening.  For example,  the swap I've been describing is an unconditional one.  Whereas you could say you're prepared to hand over £1,000 now for the privilege of receiving £1,100 in a year's time, provided interest rates don't exceed 5%.  That proviso means that in some future states of the world, you get £1,000 and in others, you don't.  The claim you have for that £1,100 in a year's time is now called a contingent claim.

Now, specifically with respect to loans and bonds.  While there a lot of historical differences between them, what are the fundamental differences between a loan and a bond.  Well, one difference is that bonds are sliced up into separate chunks - let's say in £100-sized chunks.  So in our example the £1,000 could be created as 10 separate bonds, each of face value £100.  Loans tend to be owed by a much smaller number of lenders - typically one - the bank.   That bank can surely sell its loan on to another bank, so the fact that there's a market in loans or bonds isn't a fundamental distinction between them.  However, bonds are designed to be more liquid.  People have the flexibility to operate in these convenient chunks.  This allows the possibility for a more liquid market - one that might even have its own exchange.  In some general sense, the bond's terms favour or are designed to expect that it might be owned in turn by quite a few different people/institutions.  Loans traditionally haven't been so designed.  The loans market, therefore, tends to be a lot more specialised in terms of the participants than the bond market.

If you were on the executive board of the company in question which needs that £1,000 - which would you prefer - to be beholden to a single bank (or a small number of them), versus to be beholden to a broad set of owners, not one of which feels sufficiently 'in the driving seat' to dictate additional terms to the company?  I would say that, insofar as the company is mature enough to issue bonds, and assuming the fee structures could be made fairly similar, there's still be a reason why corporate managers would prefer bonds.

So liquidity of market and diversity of the debt holder base is one clear fundamental difference between a loan for £1,000 and a corresponding bond issue worth the same.

The second major difference is where you get placed in the queue for pay-off in case the company enters bankruptcy.  Loans appear earlier in the queue than bond holdings.  In other words, in the case that the company gets into trouble and enters bankruptcy, then the loan owners get paid first when liquidating the company's assets, compared to the bond holders.  Equity holders come last in that list.  This pecking order is part of what is defined as the company's capital structure.  This is actually a bunch of laws common to all companies domiciled for legal purposes in that legal jurisdiction.  This legal framework goes a long way to determining the structural detail of the securities industries of that region, and it is arrived at through many decades - centuries in many cases - of legal precedent and case law on contested contracts.

So, whilst there are many reasons why a company's capital structure will look the way it does at any one particular moment in its life, it'll in the end reflect the company's history of decisions about how many terms and conditions it is bound to put up with around borrowing from, say, a small number of lending institutions, versus lending via a liquid bond market with a diverse range of bond-holders.   While in theory there can be international dimensions for both loans and bonds (your 'local' bank for loans can in some cases be an international organisation), it is clear to see how bonds are potentially more globalised - which in turn means a  potentially wider set of possible lenders.  This wider selection should lead to, all other things being equal, a better set of terms and conditions for the loan of the money.

Lending banks get their funds from a number of sources, but the characteristic source of funding is by current accounts and savings accounts.  Savers get a low rate of return when they put their money in a bank, and that bank aggregates all those accounts up, and lends out on a longer term basis, charging a higher interest rate then that which is paid to the current and savings account holders.  The bank makes on the spread.  In practice, banks also go to the capital markets for their short term funding needs.  Doing this too aggressively is what singled out the failing banks on the 2008 crisis.  So here the savers don't make the lending decision directly, in a sense they our-source that credit-allocation decision to the banks.  Whereas with bonds, the investor base gets to make that investment decision themselves.  That's another major fundamental difference - that the original providers of the capital have transferred the credit allocation decision to the lending institution, whereas with bonds, that stays closer to the bond owner - the capital provider.

To summarise, while in the end this is all a case of capital providers striking contracts of varying complexity to lend money to a company, specific differences are along the lines of

  1. the diversity of the capital provider base (a small number of concentrated owners versus a wide base)
  2. who decides on credit allocation (does the capital provider out-source that decision to a bank, or does he perform the operation himself)
  3. the liquidity of the security (local and illiquid versus global, standardised and liquid)
  4. the legal pecking order of repayment in the event of corporate default (the capital structure)