company has two sources of capital: (i) Equity and (ii) Debt. But there are certain sources that are in between equity and debt. One such instrument is the optionally convertible bond or optionally convertible debentures, commonly referred to as OCBs or OCDs, respectively. I’ll refer them here as OCDs.
An OCD is a bond that can be converted into a specified number of equity shares at the option of the bond holders.
Before we understand why companies issue OCDs, let us understand certain fundamentals.
How OCDs work
Let us understand it with an example.
A company issues an OCD with a face value of Rs.100 with 9% coupon and convertible into 4 equity shares at the option of the bond holder. The bond will mature in five years and the bond holder will have the right to convert the bond into equity on the 3rd, 4th, and 5th anniversaries.
In the above situation, unless the investor converts the bond into equity shares, the investor will periodically receive a coupon of Rs.9 every year. And at maturity, the investor will get the face value of the bond back. If the investor converts the bond into shares, then the company will take the bonds back and issue an equity share. As an equity shareholder, the investor will be entitled to any dividend the company offers.
Under what circumstances would bond holders convert?
In the above example, one bond with Rs.100 face value can be converted into four shares. That means the effective purchase price of a share would be Rs.25 for the holders of the OCDs.
If the actual market price of the share is more than Rs.25, say Rs.30, then the bond holders can convert the bond into shares and sell the shares in the market. That way, they would be able to receive a higher amount of Rs.120 i.e., 20% more.
In reality, the market price of the bond could be different from the face value. But, for the purpose of this blog, we shall not get into that.
Why do companies issue optionally convertible bonds?
The most common reason for issuing an optionally convertible bond or a debenture is to provide a higher reward to lenders for taking higher risk.
Another reason for issuing them is when there is a lack of consensus between investors and the company on valuation of equity shares. Most often, companies use compulsory convertible debts (CCDs) than OCDs when there is concern on valuation. However, OCDs can also work in certain situations as elaborated later.
Optionality as a reward for junk debt investors
We shall illustrate this with a simplified example.
A project requires CUR 10 million of capital. The company intends to fund this project with CUR 3 million of equity (by issuing 300,000 shares at CUR 10) and CUR 7 million of debt. Let us say this project has three possible outcomes from this project: (i) The project may entirely fail and nothing could be recovered (ii) The project may return CUR 18 million in five years, and (iii) It may return CUR 50 million in five years.
As you can see, this is a high-risk-high-reward project for equity investors. But what does the lender get? In scenario 1, the lender is likely to lose all the money, while in scenarios 2 and 3, the lender would merely recover the principal with interest. Scenario 3 does not offer anything extra to the lender despite returning huge profit.
Since the risk is very high, the lenders may demand a very high rate of interest – say 20%. But it may be difficult for the company to service such a high rate of interest in the initial years. It may lead the company into bankruptcy. In the given case, as you can see in exhibit 1, if the company agrees to such a high rate, equity investors would lose more than 80% of their investment even in scenario 2, despite it being a profitable scenario.
Exhibit 1: Rewards to equity and debt holders on high fixed interest rate debt
In order to make the lenders agree to a lower interest rate, the company may offer them an additional option to convert the bonds into shares. So, let us say, the lender agrees to 12% interest rate with an option to convert bonds into shares at CUR 35 per share. In other words, lenders would get 200,000 shares (7 million divided by 35) if they choose to convert.
Now, let us see in exhibit 2, how the rewards stack up. In this exhibit, we assume that in scenario 1 the project return CUR 3 million.
Exhibit 2: Rewards to equity and debt holders when OCDs issue for lower interest rate
As you can see in this exhibit, by taking a lower rate of interest, the lenders only receive CUR 12.3 million in scenario 2 as opposed to CUR 17.4 million as shown in exhibit 1. But by taking a lower interest they give themselves an opportunity to earn higher rewards if the project performs well, such as in Scenario 3.
This also works well for the equity investors as their chances of earning profit go up. In this arrangement, when the project only yields a moderate return, as in scenario 2, the equity investor may still earn a moderate return. In exchange, they give up some amount of superior returns, if the project performs exceptionally well.
Optional bonds to handle valuation discrepancies
Another potential use of optionally convertible bonds is in the case of private equity investments of a stable company in which the investors and the company are unable to come to a consensus on fair value.
So, let us say a company thinks that its shares are worth CUR 100 per share, while the investor believes that the shares could be worth only CUR 70. Since there is no consensus, a deal cannot be brokered.
One way to break the deadlock is through an OCD. So, instead of investing in shares, the investors could invest in optionally convertible debt. For example, let us the OCD has the following features:
Coupon rate: 10%
Time to exercise option: 5th year
Conversion price: 150
In this case, if the company’s share does not perform well and it is below CUR 150, the investors could choose to opt for the redemption of their bond and get their money back having earned a 10% return. On the other hand, let us say they find buyers who are willing to pay CUR 200 for a share, the investor can convert their bond into equity shares and earn an additional reward of Rs.50 per share.
Such an arrangement works well for both the players.
The examples given above are fairly simplified in order to not overwhelm the readers with complex mathematics. If you would like to understand mathematics better, you can go through MS Excel file available, here.