Convertible Bondholders Caught Between Devil and Deep Sea

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How can a company raise money?

This could be done by issuing equity shares or borrowing the money. If the company chooses the first option, equity base of the company goes up. Similarly, the second option, i.e. borrowing will lead to an increase in debt, thereby an increase in Debt-equity ratio. Simple, right? But wait... as they say, there is no shortage of financial engineering and innovation, we have convertible bonds.

A convertible bond is a bond issued by a company which gives the bondholder the option to trade in the bond for shares in the company that issued it. Here, the bondholder gets both a fixed-income investment with coupon payments as well as the potential to benefit from an increase in the company's share price. As the bondholder gets an option of converting a bond to equity share, the coupon payment on the bond will be lower than that of an equivalent bond with no conversion option.

Convertible bonds have further variation. We have a domestic currency convertible bonds and dollar-denominated convertible bonds. Here, one needs to ask a question. Why would a company issue dollar-denominated convertible bonds?

The quantitative easing by the US Federal Reserve led to the flow of money and low interest, prompting many Indian companies to tap the overseas market with bond offerings.

As per an article in Mint, sales of all types of US currency bonds by Indian companies surged about sevenfold this quarter. While most of those sales have been by higher-rated issuers, the convertible market flags the pitfalls of investing in weaker companies. Software maker Rolta India Ltd earlier this year became the first Indian issuer to default on its regular dollar notes in the past decade.

So dollar-denominated convertible bond is a cheaper option compared to borrowings from the domestic market. Now, say a company who had raised a loan at the rate of say 12%-14% from the domestic market have an option of re-structuring loan by issuing a dollar-denominated loan at the rate of 4%-5% (considering a company belongs to the investment grade category)

Maybe this is the reason that of US currency bonds by Indian companies surged about sevenfold. The wave of convertible bond restructuring is a symptom of the excess leverage taken on by such companies in earlier years.

Another worrying fact. A total of US $1.6 billion of US dollar convertible bonds, or 51.4% of the total amount outstanding, are due to mature by the end of 2019, according to data compiled by Bloomberg. This is because a lot of the notes are linked to shares trading below their conversion prices, investors haven't been able to exchange them to equity.

Now what will happen?

With rising maturities over the next few years, we can expect another wave of convertible bond restructuring coming up.

Here, it is important to note that convertible bondholders are unsecured creditors and won't get much through a winding up process so the only option that convertible bondholders have is to restructure. This is because, bank lenders have the upper hand in negotiations, leaving convertible noteholders with poor recovery prospects.

Although, there is reason for optimism with the nation's new bankruptcy law but it is as yet untested. As mentioned earlier, if the convertible bondholder is in a situation where there is a lot of bank debt and very little convertible bonds, the bank lenders will have more clout.

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