Published April 16, 2009

Return of convertible bonds a good or bad thing?

By CHEW XIANG

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CONVERTIBLE bonds after a six-month hiatus are making a comeback. Last month, steel giant ArcelorMittal issued 1.1 billion euros (S$2.2 billion) of the stuff, more than the 750 million euros originally planned. In the US, another US$2.7 billion in convertibles have been issued so far this year. Alcoa issued US$575 million while Cap Gemini has launched a 500 million euro issue.

In Singapore, United Engineers sold S$133 million in a rights issue of convertible bonds while WBL Corp is selling up to S$159.7 million in a similarly structured, though differently priced, deal. Transcu, a Japanese biotech firm listed here after a reverse takeover, said it was raising up to S$80 million in one-per cent notes, while TTL Holdings could get its hands on up to S$40 million from an American fund.

Appeal

The appeal of these hybrid debt-equity instruments is that they allow companies to raise cash at far less punitive rates than vanilla bonds - or from banks and shareholders' piggy banks, for that matter. Investors profit when the stock recovers, making convertibles attractive while share values are depressed but cash is still tight.

They were unpopular for a bit, when banks were pulling credit from anyone whose balance sheet was remotely creaky, but now their counter-cyclical stars appear to have risen, which is no surprise. The New York Times said - way back in 1904 - that 'at times when the condition of the securities markets renders difficult the flotation of ordinary stock issues . . . the expedient has in several instances been adopted of selling a security that has something of the nature of both a bond and a stock, in other words, the convertible bond.'

So bonds are back - but is that a good thing or bad, and what do they say about the companies that issue them? The New York Times of 1904 had this to say: 'The very feature that makes such issues attractive during periods of market depression makes them more or less troublesome to the management of corporations and to those holding the controlling interest in corporations during periods of market prosperity.'

Shorn of the fin-de-siecle verbiage, their argument is that converts are bad for management and shareholders when the market turns.

In theory, unconverted notes are a hefty overhang that may weigh the stock price down when the broad market gains. As values go above the strike price, short term investors - and if you're a convertible bondholder, it's not likely you're in for the long haul - start converting and selling. The worst case is when the conversion price is floating, pegged at some discount to the market price, in which case bond holders have an incentive to short the stock and cover with converted shares. That will only drive share prices lower. Ominously, of the four issues in Singapore, three have discounted conversion prices.

Two of them, Transcu's and TTL's, in fact resemble a species of 'toxic' convertibles - featuring multiple small tranches and discounted conversion prices - that were the rage among penny stocks up until mid-2008. Foreign funds such as Pacific Capital Investment Management - which changed its name to Pacific Capital Value Limited last August following 'corporate restructuring' - were taking up hundreds of millions of dollars worth in convertibles, and according to angry company bosses, were sending their stock prices into death spirals with repeated short-convert-sell cycles.

WBL Corp's rights issue of convertible bonds is unlikely to be similarly toxic. All shareholders get a bite of the convertibles, and because of low liquidity and trading in the stock, short sellers may not find it easy to exit with their profits intact. Yet the conversion price - at a 35 per cent discount - is dangerously dilutive. Unlike a rights issue of new shares, nobody knows when the bonds will convert, and that sort of uncertainty may keep the stock from rising if the market recovers.

The second, more noxious, reason is that issuing convertibles isn't and hasn't been seen as a very good signal to send about the health and prospects of a company. That's not surprising. Transcu, for example, has been burning cash at an incredible rate.

Historical

But there's also real historical cause for the pessimism. The list of issuers in the past few years - Guangzhao Industrial Forest Biotechnology, Sino Environment, China Sun Bio-Chem, Bio-Treat, Jade Technologies, E3 Holdings, Zhonghui Holdings, China Fashion, and too many others - features the complete box-set of corporate woes. Even big, apparently well managed companies have suffered - Olam International saw its convertible debt trading at one point at 46 cents to the dollar (it promptly booked a big gain by buying back and cancelling US$117.6 million of convertible bonds, albeit at 65 cents.)

Yet all convertibles are different, with different coupon rates, maturities, redemption prices and conversion terms. There are as many types as there are issuers (except for 'toxic' issues, which have suspiciously similar termsheets). It would be unfortunate if a genuinely useful financial instrument got a bad rep simply because tinpot companies, wittingly or otherwise, over-used them, then crashed and burned.