Hybrid Debt Securities
- By Vladimir Kutsev
- Apr. 27 2010 00:00
Managing Director, Debt Capital Markets
National Bank TRUST
Convertible bonds are hybrid securities. They are bonds with an option to convert them into a certain number of the issuer’s common shares through exercising attached call options within a given period. At maturity, the face value of the convertible bonds is redeemed by the issuer. The holder of the bonds receives regular interest income and in some cases could have other property rights.
The Market for Convertible Bonds
- The use of convertible bonds to obtain liquidity is presently mainly established on the U.S., European and Japanese markets. In 2009 alone, $12.6 billion of convertible bonds were issued in the United States, with $6.27 billion issued in 2008.
- This kind of financing is also starting to develop in “transitional” economies. In Russia, convertible bonds are generally issued by first and second tier issuers and are distributed among a wide range of investors. Examples of such issuers are LUKoil, Rosneft, RBC, VimpelCom and Ammophos. Of late, we have seen issues from Evraz ($1.2 billion) and TMK ($412 million). We believe that in Russia and the Commonwealth of Independent States there is a market for the private placements of convertible bonds to both Russian and foreign private equity and distressed funds, as well as other institutional investors.
- Convertible debt financing is not only of interest to companies, but also to several sovereign issuers, as it allows them to shift the burden of financing banks and other systemic institutions from the state to private organizations. A good example of this is the issue by Chinese banks of bonds worth 40 billion Chinese yuan ($5.86 billion) in order to improve their liquidity.
- The main hindrance to the development of the convertible bond market is administrative barriers. This sort of financing is still new for the banks and governments of the emerging markets of China, Russia, Ukraine, Brazil and India. For this market to develop, administrative barriers need to be reduced and obstacles to private sector participation removed, thus allowing the advantages of convertible bonds in crisis situations to be utilized.
Issuer Benefits of Convertible Bonds
- Convertible bonds are cheaper than standard bonds as they incorporate a conversion option, the price of which is taken into account when calculating yields.
- An issuer’s leverage can be significantly lowered if the convertibility option is exercised, thus taking off its balance sheet a certain amount of debt equal to the face value of the convertible issue and increasing shareholders’ equity by the same amount, with the extra shares received by the holders of the convertible bonds.
Investor Benefits of Convertible Bonds
- Investors have the opportunity to share the gains of growth in the underlying equity.
- The instrument is highly flexible due to the possibility of converting debt into equity.
- Receipt of extra income from conversion if the issuer’s capitalization increases significantly.
- Bonds can be collateralized by fixed assets, shares or receivables.
Recommendations for Using Hybrid Financing
- Suitable when an issuer’s shareholders are prepared to concede part of their proportional share in the company. The funds raised can be used to supplement working capital or for business development.
- Can be used as part of the process of restructuring an issuer’s debt.
- Useful in financing startup projects.
- Can be attractive for financing companies with strong credit profiles and plans to hold an Initial Public Offering.
Potential and Outlook for Hybrid Financing
We see a lot of potential for the development of hybrid financing on the Russian and Ukrainian markets. This type of financing is well-established on the U.S. and European markets and is now becoming interesting for Russian and Ukrainian issuers. The main interest from investors is coming from distressed funds and private equity funds. For them, the main advantages are high profitability, with an internal rate of return of higher than 25 percent and protection in the form of the option of converting bonds into an equity stake in the issuer. There is also the fact that the bonds can be secured by real assets, receivables or shares.