Following up on Key Bond Features Part 1, let’s briefly review a few more common features.
The three features below allow investors to indirectly participate in the growth of the issuing company. Something that ordinary bond holders do not receive. Often, a very useful feature.
Remember that whenever investors receive a right or benefit from the feature, they pay for that right. You must assess whether the ability to profit from the underlying company’s growth potential is worth the cost.
Convertible Bonds
With this right or “sweetener”, bond holders have the option to convert their bonds into a fixed number of common shares of the same company that issued the bonds for a fixed period of time.
This is considered advantageous to the investor. Why?
Normally, bond holders invest in a debt instrument of a company and receive semi-annual interest payments plus a full repayment of capital at the bond’s maturity.
But the convertible bond holder gets a bonus. He has the option to convert his debt into shares at a fixed price, he can also benefit from the performance of the issuer. If the company does well, hopefully its share price will increase.
If you hold straight bonds, you do not really care how the company’s shares perform. As long as the company can service its debt, you are content. But if you own convertible debt, you can take advantage of how the company performs.
For example, you and your brother invest in debt instruments of Growthco. Your brother purchases $1000 in straight 10 year bonds with a coupon of 10% issued at par. You acquire $1000 of Growthco 10 year convertible bonds with a coupon of 5%. They are convertible at any time after 5 years at $20 per share. The share price at time of issue was $10.
Note that for the benefit of being able to convert debt to shares, you “pay” for that right via less interest income.
Over the life of the bonds, your brother receives annual interest of $100 and you receive $50. Being your brother, he enjoys reminding you that his annual income is double yours. But refuses to even spring for a beer.
In year 8, Growthco announces a cure for baldness. The share price soars to $100. You convert your $1000 face value bonds for 50 shares at $20 per share and sell the shares on the open market. You net $5000 on the transaction.
Your brother meanwhile, cannot participate in the company’s share growth. Instead, at the end of year 10, he is simply repaid his original principal of $1000.
Being a good person, you do not laugh at your brother’s result. Okay, yes you do!
Exchangeable Bonds
Very similar to convertible bonds, so do not confuse the two features.
With a convertible bond, the holder may convert the debt into shares of the same company.
With an exchangeable, the investor may convert the debt into a fixed number of common shares of a related company to the issuer. The related company is usually the parent company or a subsidiary of the bond issuer.
Warrants Attached
Warrants give the bond holder the right to purchase a certain number of common shares at a specified price for a specified time period.
In some ways, warrants are similar to convertible or exchangeable bonds as they allow the investor to participate in the performance of the issuer or related company.
The difference is that the warrants are treated as a separate asset from the bonds. As such, they can be separated from the bonds and traded on the secondary market by the holder.
We will look at warrants again in the future.
Relevance to Investing
Never a Free Lunch
There is no such thing as a free lunch. Or so the saying goes.
This is equally true in the investing world.
When considering investing in debt instruments, pay close attention to the features.
Note that a single debt instrument may have multiple features.
As you may have noticed, features are really just “embedded options” in a debt issue.
And like all options, the one holding the option must pay for it.
Features Come at a Price
If an issuer includes bond provisions that are advantageous to it, you need to extract a greater return for your money than if the feature was not present. This may be through higher coupon rates, a discounted issue price that enhances the yield to maturity, or even adding other features that sweeten the issue and offset any negative provisions.
If the issuer includes sweeteners to entice investors, that is nice. But you also need to be wary.
The option that the bond holder receives will come at a price. If you invest in bonds with sweeteners, you must learn to value the embedded option and decide if the cost is worth it.
There are formulas to value embedded options. However, that is outside the scope of our discussions.
Sweeteners Turn Bitter to Tasty
Just be aware that sweeteners may be used to make an unappealing bond issue attractive.
For example, the issuer may be offering a lower than market coupon rate on the debt to minimize the company’s interest payments. Maybe the credit rating of the issuer is too low to attract lenders on the issue’s own merit. Or perhaps the premium required for a convertible bond is too high for the potential payoff.
There are many reasons why sweeteners must be added to a less than attractive offering to enhance marketability.
In our example above, the bond issuer wished to only pay 5% instead of 10%. To attract investors, the issuer needs to add potential value in other areas. In this case, through conversion rights. Other things an issuer might do include securing the debt against specific assets, making the debt senior to other issues in repayment status, adjusting coupon rates in the event of inflation, and so on. There are many options for bond issuers to try and entice investors.
I suggest you only consider sweeteners that are of value to you.
In our brother example, you invested in the convertible debt. However, you should only have done so if you had analyzed the company and believed that a direct investment in the common shares was prudent. If, at the time you acquired the bonds, you did not see Growthco stock as a good long-term investment, you should not have sacrificed the extra interest income for the option of buying the shares.
Remember with sweeteners, the features you receive come at a price. A valuable investment lesson to remember.
