The use of convertible bonds as a financial mechanism has seen a rise over recent years, and this is largely due to the use of ‘covenant-lite’ convertible bonds. These convertible bonds are used to separate transactions, meaning that a bond will usually be written up with one covenant preventing the issuer from issuing a large number of additional equity. This means that the bondholder is protected from an increased supply of stock that would otherwise weaken the share price of the company.
Typically, when a business wishes to venture into a new project or move away from an existing or current project, it must first seek some type of financing. This financing may range from debt, equity and/or convertible debt. One of the preferred means of financing is the use of ‘covenant-lite’ convertible bond. When used for a separation of transactions, a covenant-lite convertible bond is able to limit the ability of the issuer from issuing a tremendous amount of common shares in the open market.
This limitation of the businesss ability to increase the shares issued allows the bondholder to remain in a privileged position, as the open markets potential drive downwards of the share price due to the possible influx of new shares, is greatly reduced. The reduced pressure on the share price, although it only lasts a limited period of time, will work to the advantage of the bondholder.
Additionally, the convertible bond often pays out a higher rate of interest than a normal debt instrument, lending even more protection and stability to the bondholder. Companies using the convertible bonds often use a ‘ratchet’ clause in the bond. This ratchet clause raises the conversion price if the share price of the company increases. This allows the bondholder to benefit from the rise in the share price, although the debt-holder does not participate in the rise in the value of the company.
For the company and/or business, such a bond means that the long-term debt-to-equity ratio remains unaltered, and avoids any added pressure on the current credit rating. It also ensures that debt does not remain in the form of outright cash, which does not provide any protection if the company fails. Separation of transactions also prevents situations where companies are unable to pay back the debt, as there are numerous conditions that must be met before such actions can be taken.
In conclusion, the use of covenant-lite convertible bonds in separation of transactions can be very beneficial to both the company and the bondholder. By using such bonds, the company is able to keep its debt-to-equity ratio low and its credit rating high, while the bondholder is able to receive more favorable terms, more advantageous rates of interest, and a degree of protection against downturns in the share price due to a potential oversupply of new issues of common shares.
