Convertible bonds surge highlights late stage of credit cycle

There are plenty of signs the credit cycle is advancing into its later stages and one more can be added to the list companies are issuing more convertible debt (which has features of both bonds and equities) for their financing needs.

Twitter Inc is the latest member of this group. Last weeks news that the social media platform would be added to the S&P 500 index sparked a share price rally of almost 9 per cent, as the benchmark is widely followed by passive investors.

Twitter will issue a US$18 billion 10-year convertible bond, and its face value is $1,000, it said in a stock exchange announcement on Wednesday.

The conversion price is set at US$43 per share when the stock was priced at US$37 yesterday. The convertible bonds, with a 4.5% coupon payable annually, was priced at the top end of the indicative range pitched by banks involved in the deal, according to the revised term sheet.

The company said it had entered into hedging transactions that could reduce the dilution but the extent of such a reduction was not clear. The shares fell for a session but still looked set to close the week sharply higher.

The market is heating up for convertible debt, which was created in the US during the late-1800s railroad financing boom and pays regular coupons like a bond. But in exchange for a lower interest rate and often, subordination to other bondholders in a default investors can choose whether to exchange them for stock at a pre-determined price.

What were seeing is a huge amount of new issuance, said Odell Lambroza, a portfolio manager at Advent Capital. I think companies are trying to get ahead of rising interest rates and using convertibles as growth capital.

So far this year, companies have issued 62 convertible bonds worth $22.9bn, according to Dealogic, putting the market on pace for the highest volume of issuance since the financial crisis. This is, in part, because the Federal Reserve is raising interest rates, a defining feature of the late stages of the US credit cycle. Convertible bonds are more appealing to corporate treasurers during periods of rising rates because the lower coupons reduce the costs of interest payments.

For investors, the conditions that characterise the later stages of the credit cycle make convertible bonds more interesting as well. For one, the securities are actively traded around mergers and acquisitions, because certain features allow for a wide range of outcomes. And while there has been some uncertainty about regulatory treatment of deals, the upcoming decision about AT&Ts proposed purchase of Time Warner could spark more activity, depending on the outcome.

Source: Adapted and modified from Scaggs, A Convertible bonds surge highlights late stage of credit cycle, Financial Times, June 9 2018

Answer the following questions.

Regarding Twitters convertible bonds, a fellow student asked for your advice.

a Analyse the minimum value of the convertible bond. Comparable nonconvertible bonds are priced to yield at 7% per annum.

b Calculate the conversion premium for this convertible bond.

c Discuss two reasons why Twitter will issue a convertible bond.

d Twitter plans to use the proceeds from the convertible bond to purchase new equipment for the construction of a buildings. Another alternative is to use an operating lease to serve the same purpose. State and explain three advantages of leasing.