Published: December 01, 2009
Though convertible bonds have been issued on international markets for a number of years, issuers in South Africa are only now beginning to recognize their benefits, while investors are starting to understand their attractions.
Convertible bonds include both an equity and a debt component. Investors benefit from the upside potential of an equity instrument and the certainty attached to a debt instrument. The debt component of the instrument represents the present value of coupon payments and the cash redemption value while the equity option gives the convertible bond holder the right to receive a pre-determined number of shares in the underlying company (the issuer) instead of receiving future coupons and a cash redemption at maturity.
Throughout the life of the instrument, the issuer pays interest coupons to investors until either conversion to shares, or final maturity and cash redemption, occurs. At maturity, convertibles are worth either their cash redemption value or the market value of the shares into which they are convertible (see Figure 1). [[[PAGE]]]
The number of shares underlying the instrument is determined at the outset by dividing the face value by the ‘conversion price’ which is usually set at a premium to the price of the company’s shares at the time the convertible bond was issued. The interest coupon attached to a convertible bond is usually significantly lower than that of a vanilla corporate bond with the same maturity, a result of investors being happy to receive a lower coupon for the opportunity to benefit from the share price of the issuer exceeding the conversion price during the life of the convertible bond (see Figure 2).
From the issuer’s point of view, convertible bonds are particularly suitable for companies in markets such as those which are currently being experienced, where liquidity is tight, and long-term debt is scarce and expensive.
Liquidity and refinancing risk is probably one of the biggest risks corporates are facing, at the moment. Convertible bonds are one of the options available to the corporate treasurer to successfully mitigate those risks.
Companies which have refinancing requirements essentially have the following debt funding options:
The drawback of borrowing from banks, particularly in markets of low liquidity and high interest rates, is the high cost of borrowing and general shorter maturities attached to bank funding. Bank funding could also have onerous terms attached to it which could restrict the corporate.
The drawback of borrowing from the vanilla debt capital markets, in the current environment, is the fact that most bonds are of a short-term nature and long-term funding is scarce. [[[PAGE]]]
Convertible bonds, on the other hand, give the issuer the best of all worlds. They provide a lower cash cost than straight debt, the equity option is issued at a premium to the current share price, and funding can be achieved with longer maturity dates. Issuers have access to a very broad set of investors which include fixed income, equity, hedge fund and specialist convertible investors in a very deep and liquid market.
The downside for the issuer could be the fact that the option component of the instrument could result in issuing equity, which would have a dilutionary effect on existing shareholders. It should be noted though, that this dilutionary effect would be less than if cash was raised by the issuer through a straight equity issue, because the convertible bond essentially “issues” equity at a premium through the high conversion price.
On international markets, strong investor demand has been experienced for convertible bonds with a number of companies issuing the product in recent times. Over the last year, €7bn of convertible bonds have been supplied onto the European market, with €1.9bn in May alone.
In May, the market’s appetite was tested with the supply of non-investment grade names (First Quantum, Infineon and Q-Cells). The relative success of these transactions, in particular the First Quantum issuance, highlights the depth of the market for primary supply.
South African companies that have successfully issued convertible bonds in international markets include Harmony, Aveng, Netcare and Steinhoff International. In March this year, South Africa saw the issuance of the first Johannesburg Stock Exchange (JSE)-listed convertible bond for Aquarius Platinum, the world’s fourth largest platinum producer. The transaction was well received by the market, with both local and international investor demand.
The bond was listed on the main board of the JSE Limited under the resources sector. The issuance was initially sized at R500m and was fully underwritten and lead managed by Rand Merchant Bank. The issuance was upscaled to R650m as a result of significant investor demand. The R650m raised by Aquarius through the convertible bond, together with funds raised from other capital-raising exercises, will be used to re-open its Everest mining operation, fund the purchase of Ridge Mining plc, and finance possible further acquisition opportunities in its sector.
Each Aquarius convertible bond has a face value of R10,000, a base share price of R30.51 and a conversion price of R38.13 (representing a 25% conversion premium to the base share price), fixing the number of shares underlying each bond at 262. Investors in the three-year instrument have the ability to convert the bond into this fixed number of Aquarius shares at any time after a year of issuance in the bond.
In addition, it provides them with the safety features of a debt security package as well as a twice-yearly interest payment on the bond based on the three-month Jibar rate plus 3%.
The success of the Aquarius issue has highlighted the demand which exists for convertible bonds in South Africa. The market is expected to grow in the near future with issuers and investors beginning to understand their benefits.
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