A Trend and Its Reversal
A suitably selected trend illustrates in combination a number of the factors discussed. Such was the boom of 2003 (Economist, 2003) and the subsequent fall.
The factors that prompted the surge in the early 2000s to issuance to a near-historic high are concerned with cost, capital structure, value, financial mobility, and market context:
-
The market had no appetite for equity, and at the same time companies were suffering from unpalatable gearing levels. CSs with a low coupon provided financial mobility and some reassurance to anxious investors and garnered tax advantage.
-
Hedge funds were attracted to CSs because they perceived a bargain insofar as the issue price underestimated the volatility of the equity, which meant that the call option, C in the basic formula, was undervalued.
-
Hedge funds bought the convertible, sold the debt, and kept the undervalued call option. They then sold shares short to exploit underestimated volatility.
A reversal of the trend came when
-
the volatility of equities declined;
-
companies grew wise to the excessive cost of CSs that they were suffering;
-
for tax reasons dividends increased, and this hurt short sellers who had to pay the dividends to their purchaser.
The above trend and its reversal illustrate an underlying decision process. An issue of convertibles may be based on perceived market opportunity as above. Alternatively it may be a reaction against the relative costs of issuing straight equity or straight debt. Onerous regulation may further militate against either or both straight instruments.
Making It Happen
The decision to issue CSs follows the answers to a series of questions.
-
Is there presently a “hot convertible debt window” in the market or are there contraindications?
-
Do the causes of the window or the contraindications apply to us?
-
What is our debt capacity? If we are near its limits will CSs bust us or will they enable us to stretch our borrowing?
-
Can we tailor CSs to our real investment needs? Can we at the same time mitigate agency costs?
-
What tax-planning opportunities do CSs offer? Should we prioritize other tax benefits?
-
Measurement of the parameters of the cost of capital is notoriously difficult. How reliable are our estimates? For example, how stable is our beta and how reliable is our estimate of volatility?
- Page 4 of 4
- Previous section Factors Influencing Cost
www.qfinance.com