In the current challenging market conditions, companies considering options for financing their businesses may be contemplating or may have proposed to them an issue of convertible bonds. Convertible bonds allow bondholders to convert the bonds into other securities of the issuer, customarily shares, at a conversion price set at a premium to the current share price and tend to carry a lower rate of interest than a straight bond because of the perceived value of the conversion right. As convertible bonds combine a debt instrument with a fixed income coupon and an embedded equity call option, they are described as hybrid instruments. The convertible bond market attracts a specific institutional investor base which is largely separate from traditional equity and debt investors.
Considerations for Issue
Convertible bonds can be issued by way of an open offer or a vendor placing, but in the vast majority of cases they are issued pursuant to a placing after an accelerated bookbuild process. The Pre-Emption Group treats an issue of convertible bonds as if converted in full at issue, therefore the issuer must either have sufficient headroom available under pre-emption rights disapplications from its most recent annual general meetings or use a cashbox structure. The convertible bonds documentation (set out further below) will also include an issuer covenant to ensure at all times that it has in place sufficient shareholder authority to allot shares on conversion. The issuer must also take into account any borrowing limit under its articles of association and any financial ratios under its existing commitments.
One significant attraction to issuers of convertible bonds, particularly in a high or increasing interest rate environment, is that the value of the embedded conversion right generally means that investors will accept a lower interest coupon than on a straight bond from the same issuer. Until conversion, a convertible bond operates like a straight bond, with interest payable annually or semi-annually in arrears until repayment of the bond is due at maturity, generally after five or seven years. In order for interest payments to be made without withholding tax, bonds of a UK issuer will need to benefit from the “quoted eurobond exemption” under the Income Taxes Act 2007, which requires the bonds to be listed on a recognised stock exchange (a list of recognised stock exchanges is published by the HMRC). Most commonly, UK issuers will list their convertible bonds on the London Stock Exchange or The International Stock Exchange (TISE) in the Channel Islands.
The right to convert the bonds into shares is an option that is typically exercisable by a bondholder in its absolute discretion from forty days after issue of the bonds until a date shortly before the maturity date. Conversion is effected pursuant to the terms and conditions of the convertible bonds by surrender of the bond in return for the issue of shares. The terms set the conversion price which is generally at a premium (typically between 10 and 40 per cent) to the share price at the time the bonds are issued. The number of shares to be issued on conversion will be equal to the denomination of the bond divided by the conversion price.
A convertible bond can be described as a bet on the part of both issuer and investor that the share price will appreciate above the conversion price. In that case the issuer does not have to repay the bonds at maturity and the investor profits by being able to convert into shares at a price below the share price at the time of conversion, but also has the protection of a return floor, because of the interest payable and the right of repayment at maturity. From the issuer’s point of view, this highlights the principal risk in issuing convertible bonds - if the share price never exceeds the conversion price during the term of the bonds, then the bonds will have to be repaid in full.
Conversion Price Adjustment
As the conversion price is fixed at the time of issue of the convertible bonds, provisions are included in the terms to allow for adjustments to the conversion price in certain situations whereby economic interest in the underlying share capital of the issuer may be impacted. In particular, the terms provide bondholder protection from corporate actions which dilute the value of the underlying shares (measured by reference to current market price) by allowing for adjustments to the conversion price where the issuer has made bonus issues of shares, rights issues, capital distributions (full dividend protection or above agreed dividend levels) or distributions to third parties.
Takeover/Change of Control Protection
Convertible bond terms typically include two provisions protecting bondholders in the event of a takeover offer or other change of control. In the case of an offer, the terms will provide for a ratcheting down of the conversion price in each year, so that a holder can convert at a lower price than the original conversion price in order to obtain shares and accept the offer. Alternatively if there is a change of control, whether resulting from an offer or otherwise, the terms of the convertible bond generally provide for holders to be able to exercise their put option and redeem their bonds at par.
Issuer Call Options
Sometimes an issuer may include a “hard call” option in the terms of a convertible bond, allowing it to repay the bonds early at an amount above the original issue price.
Almost universally, convertible bond terms provide a “soft call” option, allowing the issuer to repay the convertible bonds after a notice period of between 30 and 90 days, provided that the share price has been trading at a specified premium to the conversion price for a certain period, e.g. 30 trading days or 20 out of 30 trading days. Bondholders may still convert during this notice period, so the call option acts in effect as an incentive to convert and as a cap on the return to the bondholder from conversion. The soft call is usually not exercisable until a certain time after issue of the convertible bonds. If a bond is not callable until three years after issue, it will be described as a “no call three” convertible bond.
Finally, the terms generally provide for a “sweep-up” call allowing the issuer at any time to redeem all outstanding bonds if 90 per cent or more of all bonds originally issued have been converted or purchased by the issuer.
Historically, some convertible bonds have included a cash settlement option allowing an issuer to settle its obligation upon conversion, in whole or in part, in cash. Settling in cash rather than shares reduces the dilutive effect on existing shareholders and may increase available headroom for non-pre-emptive issues of shares. Cash settlement options have become less frequent in recent years, as accounting rules now treat such options as revalued each accounting period and increases in underlying share price can create volatility in the issuer’s accounts. Instead, issuers tend to have the ability to carry out a tender offer for its existing convertible bonds, which achieves a similar result but without the impact on issuer’s periodic accounting.
Covenants and Events of Default
Convertible bonds will generally not include covenants other than a negative pledge. In the context of bond issues, the purpose of negative pledge clauses is to protect the price of the issue by preventing similar issues by the issuer on a secured basis, and therefore typically a negative pledge clause in a convertible bond issue will only prohibit granting of security for other listed bonds. The package of events of default will reflect the credit quality of the issuer and typically include failure to pay, breach of covenants, cross default (if the issuer defaults on another obligation), acceleration and winding up, insolvency or similar proceedings.
Process, Legal Documentation
In most cases, a convertible bond issue will require a prospectus (or other listing document in the case of non-UK/EEA exchanges, such as TISE) to be published because of the need for a listing in order to qualify for the quoted eurobond exemption so that interest can be paid without witholding tax. The process may take longer than a placing of equity by a listed company because the arranging banks may need to have identified in advance holders of the issuer’s shares who may be prepared to lend shares to investors targeted in the marketing process to allow them to hedge their investment. The process of having a prospectus approved can be achieved within a couple of weeks and can be undertaken ahead of announcement and marketing or, given no prospectus is required for institutional marketing, after the bookbuild. In such a case, settlement may be delayed until prospectus publication or the terms and conditions of the convertible bonds may provide for automatic redemption if a prospectus is not approved by a certain date. On conversion, the production of a prospectus in respect of the underlying shares being issued is not usually required, unless the shares represent 20 per cent. or more of the shares of the same class already admitted to trading on the same market.
The main process items ahead of launching a convertible bond issue will be internal and external authorisations (as mentioned above), appropriate due diligence process, marketing term sheet and press releases, and legal documentation.
Apart from the prospectus or other listing document, the main transaction documents for a convertible bond issue will be terms and conditions of the convertible bonds, which are either included in a trust deed constituting the bonds or, in the absence of a trustee, endorsed in the global bond certificate, a subscription agreement (setting out, inter alia, representations and warranties in relation to the issuer and the underlying shares and issuer’s indemnity to the banks acting on the issue), and an agency agreement (reflecting the payment and conversion procedures).