Convertible Bond - Types

Types

There are many variations of the basic structure of a convertible bond.

• Vanilla convertible bonds are bonds which may be converted at the option of the owner into the shares of the issuer, usually at a pre-determined rate. They may or may not be redeemable by the issuer prior to the final maturity date, subject to certain share price performance conditions.
• Exchangeables (XB) are bonds which may be exchanged into shares other than those of the issuer. Strictly speaking, they are not convertibles, but they share certain common evaluation characteristics.
• Mandatory convertibles are short duration securities—generally with yields higher than found on the underlying common shares — that are mandatorily convertible upon maturity into a fixed number of common shares. If it is intended to provide a minimum value for the convertible at maturity, convertibility may be into a sufficient number of shares based on the stock price at maturity to provide that minimum redemption value.
• Mandatory exchangeables are short duration securities—generally with yields higher than found on the underlying common shares — that are mandatorily exchangeable upon maturity into a fixed number of common shares. Likewise, if it is intended to provide a minimum value for the convertible at maturity, exchange may be into a sufficient number of shares (based on the stock price at maturity) to provide that minimum redemption value. Such exchangeables may be said to be "redeemed into equity", and care should be taken when reading the offering documentation, lest "redemption" and "conversion" are confused.
• Contingent convertibles (co-co) only allow the investor to convert into stock if the price of the stock is a certain percentage above the conversion price. For example, a contingent convertible with a $10 stock price at issue, 30% conversion premium and a contingent conversion trigger of 120%, can be converted (at $13) only if the stock trades above $15.60 ($13 x 120%) over a specified period, often 20 out of 30 days before the end of the quarter.

The co-co feature was often favored by issuers because the shares of underlying common stock were only required to be included in diluted EPS calculation if the issuer's stock traded above the contingent conversion price. In contrast, non-co-co convertible bonds result in an immediate increase in diluted shares outstanding, thereby reducing the EPS. The impact to diluted shares outstanding is calculated using the "as-if-converted" method, which requires the most conservative EPS value be used. Recent changes to GAAP have eliminated the favorable treatment of co-co's, and as a result their popularity with issuers has waned.

Another type of co-co's issued by some banks convert into stock if the core capital of the bank falls below a trigger level.

• OCEANEs (or Obligation Convertible En Actions Nouvelles ou Existantes) are bonds which may be converted into the equity of the issuer, but the issuer has the right to deliver new shares or old shares held in Treasury (possibly with different dividend rights). They are a common structure for French issues. These bonds are technically not convertibles, as defined by the law of 25 February 1953. Consequently, there is no three-month conversion period for investors following the date that bonds called are due for redemption, (as is otherwise required, under French law, for French convertibles).

• Convertible preferred stock, (convertible preference shares in the UK), is similar in valuation to a bond, but with lower seniority in the capital structure. Non-payment of income is generally not regarded as an act of default by the issuer. The terms of each issue will define whether or not entitlement to unpaid preference income is cumulative.

• SPV structures Many convertibles, particularly Euroconvertibles, are issued through special purpose vehicles (SPVs), (typically a subsidiary based offshore in British Virgin Islands, the Cayman Islands or Jersey). The SPV debt is convertible (exchangeable to be more precise) into the equity of the parent company, which is often a holding company. Although the parent may guarantee the SPV debt on an unsubordinated basis, the assets of a parent company could just be shares of various subsidiaries. This means that nominally unsubordinated guarantee on the debt could in fact be structurally subordinated. More significantly, the basis of seniority upon which money raised by the issuing entity has been onwardly applied is rarely revealed at issue; if on-lent on a subordinated basis, the asset quality of the issuing entity and its debt is impaired. This creates a fundamental weakness in the credit analysis of any convertible and non-convertible SPV debt.

• Reverse convertible securities are short-term coupon-bearing notes, structured to provide enhanced yield while participating in certain equity-like risks. Reverse convertibles securities are most commonly targeted towards the US market. Their investment value is derived from underlying equity exposure, which is paid in the form of fixed coupons. Generally speaking, the higher the coupon payment, the more likely it is that the investor is delivered shares on maturity. Investors receive full principal back at maturity (plus accrued interest) in cash (but no more) if the Knock-in Level is not breached at any time during the life of the security. The Knock-in level is typically 70-80% of the initial reference price. The underlying stock, index or basket of equities is defined as Reference Shares. In most cases, Reverse convertibles are linked to a single stock.

• Going-public bonds are fixed interest securities which convert or exchange into shares of a company when it later achieves a stock market listing. Distribution is initially syndicated to sub-underwriters, this distribution typically being helped by a short-term redemption feature, possibly in equity, at or near the subsequently prevailing share price. This reduces the downside risks to sub-underwriters taking bonds at issue. Some time subsequent to their issue, the bonds become convertible or exchangeable into shares, the conversion price reflecting in some measure the share price (or expected share price) at the time of conversion – and may be fixed at a discount, to encourage conversion. The key element of going-public bonds is that the primary distribution date is de-coupled from the date when the conversion or exchange price is fixed. In France a series of such bonds were known as Balladur bonds.

• Hybrid bonds typically are issued as loan capital, but the issuer retains the right to exchange or convert the bonds into convertible preference shares with similar conversion rights and income. The purpose is generally to ensure that the bonds (as loan capital) have the tax offset-ability (against taxable profits) of loan interest, and perhaps pay gross to qualifying investors. At the same time, the ability to change the bonds into cumulative or non-cumulative preference capital should mean that they pose less balance sheet risk. The issuer only achieves the best of both worlds if the hybrid bond is structured so that non-payment of interest does not constitute an event of default.