ISBN: 0-03-028931-9

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants and Convertibles

Taking a Wild Ride with Amazon's Convertible Debt

The use of convertible securities-generally bonds or preferred stocks that can be exchanged for common stock of the issuing corporation-has soared during the last decade. At the start of 2000, $140 billion of convertible securities were trading in the market.
Why do companies use convertibles so heavily? To answer this question, recognize that convertibles virtually always have coupon rates that are lower than would be required on straight, nonconvertible bonds or preferred stocks. Therefore, if a company raises $100 million by issuing convertible bonds, its interest expense is lower than if it financed with nonconvertible debt. But why would investors be willing to buy convertibles, given their lower cash payments? The answer lies in the conversion feature- if the price of the issuer's stock rises, the holder of the convertible can exchange it for stock and realize a capital gain. So, convertibles hold down the cash costs of financing by giving investors an opportunity for capital gains.
A convertible bond's value is tied to the price of the stock into which it is convertible, whereas a nonconvertible bond's price is based on its fixed-income payments. Therefore, convertibles' prices go up and down much more than regular bonds' prices; hence, convertibles are relatively risky. A recent article in Forbes reported that if a company's common stock increases in value, the returns on its convertibles also rise, but by only 70 percent of the stock's percentage increase. However, if the stock declines, the convertible will decline by only 50 percent of the stock's decline. Thus, while convertibles are more risky than straight bonds, they are less risky than stock.
To illustrate all this, consider the convertible bonds recently issued by Amazon.com. In January 1999 Amazon issued $1.25 billion of convertible bonds, the largest convertible bond offering in history. Amazon's bonds were issued at a par value of $1,000, and they had a 4.75 percent coupon rate. Because they can be converted to Amazon common stock, changes in the stock price will have a profound effect on the convertibles' value.
During 1999 Amazon's convertibles took their holders on a wild ride. During the first four months Amazon's stock rose about 70 percent, causing its convertibles to rise by 50 percent, to $1,500. During the next four months, the stock lost more than 60 percent of its value, to a level 30 percent below where it was trading when the convertibles were issued. This caused the convertibles' price to drop to $750. Three months later Amazon's stock had rebounded, and its convertibles were once again trading above $1,500, only to decline sharply one month later. By year-end 1999, the convertibles were about back to their $1,000 issue price. Thus, a convertible bondholder holding the bond for the entire year would have ended up close to where he or she had started, with a total return just shy of the 4.75 percent coupon rate.
Not all stocks are as volatile as Amazon, so not all convertibles take their investors on such a bumpy ride. However, the Amazon experience does illustrate that convertibles can be quite risky. Some do fabulously well, while others are terrible dogs. For example, in 1997 American Online (AOL) issued a five-year convertible bond with a 4 percent coupon. Then AOL's stock price exploded, and the value of its convertible bonds increased from $1,000 in November 1997 to more than $11,600 in early 2000. On the other hand, convertible bondholders of Boston Chicken (later renamed Boston Market) saw their investment evaporate as the once high-flying company crashed. Many similar stories of both types could be told.
When you finish this chapter, you should have a good understanding of what convertibles are, how they are valued, and why a firm might choose to issue a convertible bond rather than either straight debt or common stock.

DISCUSSION QUESTIONS

1. Many of the recent high-profile convertible bond issues have come from internet companies. Do you think it is a good or bad financing decision for Internet companies to use convertibles? Why?
2. How do you think the convertible bond market would react to declining (or increasing) interest rates? To equity market growth?

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