Convertible notes are a type of hybrid security. Hybrids are listed securities that incorporate features of both debt and equity. The Australian Securities Exchange’s (ASX’s) interest rate security market was capitalised at around $23 billion in March 2011. The main type of hybrid traded on the ASX is the converting preference. Convertible notes are a relatively small sector of the market, and are a method of fund raising used primarily by smaller companies. Convertible notes combine features of corporate bonds with the option to convert the notes into equity in the issuing company. Now we shall explain the main features of convertible notes, and highlights the exposure they offer to the performance of the underlying company’s ordinary shares. Methods of evaluating risks and returns are also considered.
The Australian Securities Exchange (ASX) interest rate securities market comprises:
- corporate bonds and floating rate notes
- converting preference shares
- convertible notes.
Convertible notes are a relatively small sector of the stockmarket. There were 19 notes listed in March 2011, with a total market capitalisation of around $1.9 billion. Most issues are under $100 million. ASX puts annualised liquidity of convertible notes at 21%.
What are convertible notes?
Convertible notes can be thought of as a bond with a conversion feature. The main ‘bond-like’ features are that the note pays regular interest to the holder, and that at maturity, the face value of the note is repaid to the holder. Unlike the holder of a corporate bond, however, the holder of the note also has the right to convert the note into ordinary shares in the issuing company at specified times. If the investor holds the notes until maturity without converting them, the issuer pays the face
value of the note to the holder. Notes can be bought at the time of issue directly from the issuer. Investors who subscribe for notes on the primary market will pay the note’s face value.
Once the notes start trading on the ASX, investors can buy on-market, paying the current market price — which is usually different from face value. The holder can also sell the notes on-market prior to maturity, in which case they will receive the current market price. Investors looking to buy or sell on-market should be aware that there may be low liquidity in some convertible note issues.
Convertible notes pay regular income in the form of interest. Interest is generally paid either quarterly or semi-annually. This is an important point of distinction from the payment stream derived from a converting preference share. Converting preference shares generally pay income in the form of dividends, which may be franked.
The form in which payment is made also is also relevant to the ‘priority’ of the payments. Interest payments rank higher than dividend payments to both ordinary and preference shareholders.
The issuer sets the payment rate (coupon rate) at the time of issue of the notes. Convertible notes can pay either a fixed or a floating rate of interest, with the majority paying a fixed rate. With a floating rate, interest payments are linked to a market reference rate, typically the Bank Bill Swap Rate (BBSW). The issuer specifies a margin to be added to the reference rate. As the market rate changes, payments are adjusted.
The rate specified might be BBSW + 4.0%. On a regular basis, typically quarterly, the issuer refers to BBSW and adds the margin of 4.0% to arrive at the distribution rate for that quarter. While the benchmark rate varies over time, the margin is generally fixed.
The payment rate is expressed as a p.a. percentage of the face value of the notes. Risk of non-payment or deferral of interest The terms of issue may give the issuer the right either to defer interest payments, or to make payments in a form other than cash. It is essential to read the prospectus carefully to determine if the issuer has such rights.
The issuer may have the right to defer interest payments for a specified period — possibly several years. This clearly has implications for noteholders who rely on their investment income.
In some cases, the issuer may also have the right to issue shares to noteholders in lieu of making cash payments.
Convertible notes give the holder the right to convert the notes into ordinary shares in the issuing company at specified times. The holder has the right to convert at maturity, and will also generally have the right to convert at various times before maturity. In some cases, certain dates may be specified. In others, the holder may have the right to convert at any time after the date of issue, or at any time after a specified date. Again, the prospectus should be referred to for details. If the holder does not exercise the right to convert at or before maturity, the issuer pays the holder the note’s face value in cash. Some notes are ‘perpetual’, meaning they have no maturity date. In this case, the company pays interest for as long as the investor continues to hold the convertible note.
Convertible notes convert into a fixed number of ordinary shares. This is a second important point of distinction from converting preference shares, which generally convert into a fixed dollar value of shares, and has important implications for the way the price of the convertible notes moves.
The fixed conversion rate means that the price of the note tends to move in line with the price of the company’s ordinary shares. In contrast, the price of a hybrid that converts into a fixed dollar value of shares, such as a converting preference share, tends to be far more stable. In the case of the converting preference share, the ordinary share price is in a sense immaterial. If the share price falls, the investor simply receives more shares on conversion. If it rises, the investor receives fewer shares. One convertible note typically converts into one share, although it is possible that a note may convert into multiple shares.
If a convertible note converts on a on a 2:1 basis, the investor will receive two ordinary shares for each convertible note. If the investor holds 2000 notes, these can be converted into 4000 ordinary shares in the company.
Pricing, risk and return
Various measures of risk and return are used to evaluate and compare one issue of convertible notes with other issues of convertible notes, and with other interest rate securities. Some of these measures are:
Coupon rate, which refers to the interest paid annually, expressed as a percentage of the note’s face value. As explained in the earlier section on income, a fixed rate is expressed as a simple percentage (for example, 12% p.a.) while a floating rate coupon is expressed as a reference rate plus a margin (for example, BBSW + 4.0%).
Running yield, which is the annual distribution expressed as a percentage of the current market price of the note. The running yield varies as the price of the note changes. Both these measures take into account only the income derived from the note and not the potential capital gain or loss from it. As is the case for other types of interest rate securities, yield to maturity (YTM), and the trading/swap margin are generally regarded as the most useful measures of return, as they take into account both income and capital gain/loss. Yield to maturity (YTM) is a measure of return that captures both the income an investor will derive from a security and the capital gain or loss they will make if they hold the security until maturity. A comparison of the security’s Yield to maturity (YTM) to a low-risk market rate produces the trading margin, or swap margin. Investors can make a judgement as to whether the margin the note offers over the low-risk rate is a fair return, given the risk of the note. The swap margin is, therefore, a measure of the risk of the security, and of the issuer, as assessed by the market. The higher the perceived risk of the issuer, the greater the margin the note will have to offer in order to attract investors. A floating rate security’s yield is typically compared to the BBSW. A fixed rate security’s yield is typically compared to the rate offered by a low-risk security with a similar term to maturity. So, a trader might compare the yield offered by a note with five years to maturity with the 5-year swap rate. If the 5-year swap rate is 6% and the note has a Yield to maturity (YTM) of 10%, the note offers a margin of ‘4% over the swap rate’. An assessment must then be made of whether that margin is fair compensation for the risk of the security.
In the case of convertible notes, however, a simple comparison of Yield to maturity (YTM) to a low-risk market rate can produce a misleading result. An adjustment to the method of calculating the swap margin may produce a more meaningful result.
Option-adjusted swap margin
As previously stated, a convertible note can be thought of as a bond with a conversion feature. Both these components have a value. The bond-like returns include the interest the note pays, and the difference between the amount paid for the note and the note’s face value, which the holder receives at maturity if the note is not converted. The value attributed to the conversion feature depends on the price of the shares into which the notes will convert. The higher the share price, the more valuable the conversion feature. The Yield to maturity (YTM) incorporates both these elements. However, the value of the conversion feature is not really a reflection of the risk of the issuing company, rather it is a reflection of the ordinary share price. Comparing the Yield to maturity (YTM) to a low-risk market rate can, therefore, produce a distorted result, particularly if there is significant value attached to the conversion feature due to the ordinary share price being much higher than the face value of the note.
For the swap margin to be a useful measure of the note’s risk, the value of the conversion feature needs to be stripped out to isolate the bond-like returns, before making the comparison with the swap rate. The conversion feature is essentially a call option held by the investor. Traders, therefore, talk of two measures — the ‘swap margin’, and the ‘option-adjusted swap margin’. The latter is generally regarded as a more accurate reflection of the bond-like returns from the security. The method of calculating the option-adjusted swap margin is beyond the scope of this article. Brokers who specialise in advising on interest rate securities are able to provide these figures.
What happens at maturity
As maturity approaches, it is essential for the investor to compare the value of the shares they would receive on conversion of the note with the cash payment they will receive if they do not convert the note. If the investor takes no action to convert the note, the issuer will pay the face value in cash. If the ordinary share price is above the note’s face value, the ‘exit value’ received will be less than would have been received if the holder had exercised the right to convert. Similarly, if the ordinary share price is below the note’s face value, the investor will generally be better off taking the cash payment of face value.
Issuer rights to redeem or convert
Investors should always read the prospectus to check whether the issuer has the right to redeem or convert the notes ahead of maturity. These rights are generally only exercised if the ordinary share price has risen substantially above the issue price of the note.
If the issuer has the right to redeem the notes early, they will generally announce this to the market and notify noteholders that they intend to redeem. Noteholders will then usually have a specified period before the redemption date in which they can convert their notes into shares if they wish.
The issuer may also have the right to enforce conversion before the maturity date of the notes in specified circumstances. These circumstances are typically when the ordinary share price is trading at a specified premium to the notes’ face value.
The prospectus may give the issuer the right to enforce conversion if the average trading price of the shares over a certain period is at a 40% premium to the face value of the notes. If conversion into shares is enforced, investors will have to consider whether they wish to hold the ordinary shares, given the altered exposure. Particularly relevant is that:
Income will now be received in the form of dividends on the ordinary shares instead of interest from the notes, and may well be lower. The dividend rate can also be altered at the company’s discretion, whereas the payment rate on the notes is set at the time of issue.
The shareholder is fully exposed to a fall in the share price, and no longer has the noteholder’s security of being able to receive face value in cash at maturity.
Ranking and security of convertible notes
We have previously mentioned that noteholders rank before shareholders for the payment of distributions (that is, interest must be paid to noteholders before any dividends can be paid to shareholders). However, convertible notes are subordinated debt, so rank below senior debt such as bank loans. Convertible notes are typically unsecured. If the issuer gets into financial difficulty and ultimately goes into liquidation, secured creditors have a prior claim on proceeds from the sale of company assets. However, convertible noteholders rank before shareholders, so must be paid face value of their notes before shareholders receive any proceeds from liquidation.
Convertible notes vs convertible preference shares
The main differences between convertible notes and converting preference shares have been discussed throughout this post.
Figure “Convertible notes versus converting preference shares” - summarises the differences between a typical convertible note and a typical preference share.
Feature Convertible notes Converting preference shares
Distributions Interest Dividends
Conversion Converts into a fixed Converts into a fixed
mechanism number of shares dollar value of shares
Price relationship Tends to move in line Generally stable,
to ordinary shares with ordinary share price independent of
ordinary share price
At maturity Face value repaid in Generally converts
cash if not converted automatically into
Ranking Before shareholders Before ordinary shareholders,
(ordinary and preference), after creditors
after secured creditors
Convertible notes are a relatively small sector of the ASX’s listed interest rate security market. They are a means of fund raising used typically by small companies, with issues generally less than $100 million. Convertible notes pay regular interest, and return the face value in cash to the holder at maturity if the notes have not been converted. At maturity, and at specified times prior to maturity, the holder has the right to convert the notes into ordinary shares in the company. Notes convert into a fixed number of shares, usually on a 1:1 basis. Because of the conversion mechanism, the price of convertible notes tends to move in line with the ordinary share price, giving the noteholder significant exposure to the company’s share price performance. This is an important point of difference from converting preference shares. Convertible noteholders rank ahead of shareholders, but behind senior creditors, for the payment of interest and the repayment of capital.