Fair exchange

With the recent success of last December’s landmark issue by UniCredito Italiano Bank (Ireland) of €1.263bn (£840.7m) of exchangeable bonds – the first such by an Irish bank or other Irish issuer – Irish companies looking for new ways to raise finance and tap increasing investor appetite for equity-linked paper have begun to consider equity-linked debt issues. This article considers two of the main classes of equity-linked debt issues – convertible bonds and exchangeable bonds – and some of the issues surrounding them.

What are convertibles and exchangeables?

A convertible bond is one that can be converted into the shares of the issuing company at the option of the bondholder. An exchangeable bond differs from this in that it is exchangeable for shares in a company other than the issuing company. Unless the bond issue has special features, the issuer will usually commit to paying periodic interest on the bond and repay the principal on maturity, as would be the case with most ordinary bond issues. The principal added feature that convertible or exchangeable bonds have is that the holder may elect to have the bond converted or exchanged into a fixed number of shares. Convertible and exchangeable bonds, therefore, combine the characteristics of straight bonds and equity derivatives.

The bond specifies the conversion price at which the shares may be acquired. On conversion or exchange, no consideration is payable – the subscription price is paid by a set-off of the principal amount of the bonds, which are surrendered on conversion or exchange, against the obligation to pay this price. For example, if the conversion price is €100 per share, then the holder of a €1,000 bond would, on conversion, receive 10 shares (ie 1,000 divided by 10) in exchange for the bond.

The difference between the market price of the underlying shares at the time of the issue of the bonds and the conversion price is the conversion premium. The amount of the premium is determined by such factors as the relevant company’s prospective growth rate (being the issuer itself in the case of convertible bonds or another corporate in the case of exchangeable bonds) and the relative need to attract investors. The bondholder, therefore, speculates in the hope that the share price will eventually exceed the conversion price so that they can acquire the shares inexpensively. Investors will therefore accept a lower coupon rate paid on convertibles or exchangeables because of the potential profit should the share price increase, while the issuer in return receives lower funding costs in exchange for potentially giving up some equity. The coupon received by investors is usually higher than the dividend on the underlying equity, providing some protection to investors should the stock perform poorly (see also the use of put options).

Anti-dilution provisions

The value of the right to convert into, or subscribe for, a company’s shares could be severely eroded by action on the part of the company in which the shares are issued over which the bondholder had no control. For example, if the conversion price is €14 and a company subdivides its shares by converting €10 of shares into two €5 shares, the market value of each share would be halved. In such cases, the conversion price should also be halved, ie €7. It is usual, therefore, to ensure that the bonds contain anti-dilution features to protect bondholders against, among other things, (i) bonus share issues (value of existing shares reduced), (ii) rights issues (rights issue shares are usually issued at below market price, thereby often reducing the existing share value), and (iii) large extraordinary cash dividends or other distributions to shareholders (treated as a ‘capital distribution’ due to the reduction in value of the company, impacting on share value).

Call option

A common feature of convertible and exchangeable bonds is an issuer call option, permitting the issuer to redeem the bonds at a fixed price after a fixed date in the future if the shares reach a certain price, typically set at around 130 per cent of the conversion price. This option effectively forces all bondholders to effect their conversion or exchange, and introduces a form of timed cap on the profit the bondholders can take on the transaction. This right, however, will not usually be capable of being activated during the first few years of the life of the transaction.

Put option

Another common feature on these deals is a put option. This will usually allow the bondholder to choose to have the bonds repaid from a certain date at a premium on the bond issue price (eg exercisable from year four at 120 per cent) to give the investor a better rate of return and to theoretically put the investor (almost) in the position they would have been in had the bond yielded a normal interest rate as opposed to the lower interest rate these instruments usually attract. This helps mitigate the investor’s risk of a fall in the value of the underlying shares.

Conclusion

Convertible and exchangeable instruments, balanced to afford advantages to investors and issuers alike, have increasingly come to be viewed as mainstream investment instruments, with market appetite for these increasing accordingly. The recent success of the groundbreaking UniCredito Ireland transaction shows that Ireland can be used as an issuing venue for these exciting and interesting transactions.

Hugh Beattie is a partner-elect with the banking department of McCann FitzGerald and, together with Julian Conla, was the Irish legal adviser to UniCredito Italiano Bank (Ireland) on its exchangeable bond transaction