22nd letter to friends of Brunei [Convertible Bond (Part 3)]

In the previous blog, we learnt about why invest in convertible bond. Now, we look at why companies issue convertible bond. 

There are few reasons, but the main one is : "This is the lowest cost way to raise fund."

During 2004 - 2007, the Singapore's booming property market has led many developers rush in to buy over old apartments (hence set up the en-bloc craze) to build new property projects. The bank lending rate was around 5.25% p.a. (prime). During this period also see many developer companies, such as Soilbuild Group and CapitaLand, issue convertible bond. Why? Because the coupon rate was issued to as low as 1% p.a.  

The differential in interest rate is substantial, for example, for every $10M, the interest cost at 5.25% is $525,000, compared to 1% at $100,000.

The second reason, by fixing the conversion price at certain level, the company can fix the share price at a premium. For example, if the current share price is trading at $3, the conversion price is $4, the company can receive $3+$1 for its share price.

The drawback for company is the dilution of earning per share after the conversion, as more shares are in the market. 

Secondly, in the bull market, the mass conversion of bonds into shares and then immediate mass selling of these shares can cause the share price to plunge.  This usually happen when the business cycle turns from peak to recession. Recent huge drop of share market index is the result of this happening. 

In summary, company issue convertible bond for

1. low cost financing

2.Guarantee value of share price 

The drawbacks are

a. Dilution of EPS (earning per share)

b. Potential downward pressure on share price if mass conversion and mass selling happens