Convertible Bonds

The convertible bond is a traditional corporate bond with the additional feature of being
convertible, at the investor’s discretion, into a pre-determined number of shares of common
stock. As such, convertibles are hybrid securities that combine both equity and debt
characteristics. Through the equity characteristic, investors in convertible securities have the
potential to participate in the appreciation of the underlying stock, while the debt
characteristic offers the potential for a more limited downside than equities.

Features of a Convertible Bond

An example:

On July 2013, Kingsoft Corporation Limited 金山軟件 (3888.HK) issued the following
convertible bond.

Size: HK$ 1.356 billion

Term: 5 years
Redemption Date: 23 July 2018
Nominal Value: HK$ 1 million
Interest Coupon: 3.0%
Conversion Price: HK$ 16.9363
Conversion Ratio: 59,044.77
Market Price at Issue (%): 100
Bloomberg Ticker: KINSF 3 07/23/18
The bond has a nominal (or par) value of HK$ 1 million. The market price is quoted as a
percentage of the nominal value, which means the price at issue is HK$ 1 million. Like a
straight bond, the convertible bond pays interest semi-annually (on 23 January and 23 July
each year). For each bond, the stated interest will be HK$ 1 million × 3.0% ÷ 2 = $15,000.

The convertible bond contract states either a conversion ratio or a conversion price. A
conversion ratio directly specifies the number of shares of the issuing firm’s common stock
that can be obtained by surrendering the convertible security. In this example, Kingsoft
allows the holder in exchange for 59,044.77 shares from 2 September 2013 to 10 days before
the maturity date (13 July 2018). If the bond is not converted, it will be redeemed at par on
maturity.

Alternatively, the conversion ratio may be expressed in terms of a conversion price – the
price paid per share to acquire the underlying common stock through conversion. The
conversion ratio is equal to the nominal value divided by the conversion price. Since the
conversion price is HK$ 16.9363, the holder will receive 59,044.77 shares of common stock
in conversion, given a par value of HK$ 1 million for the bond.

The full conversion will generate 80,061,473 shares at the stated conversion price, HK$
16.9363, which accounts for 6.36% of the total issued shares. In some cases, the conversion
price is not always fixed. For example, the conversion price of this convertible bond has
been adjusted from HK$ 16.9363 to HK$16.7 in May 2015.

Call and Put Features

Many convertible bonds are callable by the issuer, which may lead to “forced conversion”.
In other words, the company has the right to convert them forcibly. Forced conversion
usually occurs when the price of the stock is higher than the amount it would be if the bond
were redeemed. In our case, the contract stated that after 23 July 2016 that, if the daily
volume weighted average price of the share exceeds at least 30% of the conversion price for
20 out of 30 consecutive trading days before the redemption announcement is made, then the
bond will be callable by the company. With the new conversion price at HK$16.7, the call
will be triggered if the bond rises to $21.71 and meets the stated requirements.

Some convertible bonds may offer a put feature which allows the holder to put back the
bonds to the issuer. This feature is also available for this bond. Kingsoft will repay the
principal plus the accrued interest to the holder on 23 July 2016, offering downside protection.
Convertible Bond Market

The convertible bond market is a relatively small market in comparison to the straight
corporate bond market.

Year No of Amount Raised No of Amount Raised

Newly Listed (HK$ Billion) Newly Listed (HK$ Billion)
Debt Security CB
2011 50 152.49 2 2.34
2012 109 341.24 0 0
2013 170 576.40 2 7.78
2014 281 961.35 6 6.76
2015 177 750.76 2 3.24

Source: HKEx

The table shows the number and amount raised for newly debt securities and convertible
bonds from 2011 to 2015. There are few convertible bonds listed and traded on the HKEx
since most bond trading is done via the over-the-counter (OTC). The convertible desks in
brokerage firms bring buyers and sellers together, and this process can take a few minutes or
several days depending on various factors such as order size and market conditions.

Why Firms Issue Convertible Bonds?

In theory, convertible bond helps to resolve some conflicts between equity and debt holders.
Shareholders can hurt debt holders by taking more risk or issuing senior debt. To compensate
for this risk, debt holders will charge a very high interest rate, which may give shareholder
incentives to take even more risk and eventually destroy firm value. However, this problem
is alleviated in the case of convertible bond since debt holders may also become shareholders.
From an informational point of view, issuing convertible bond signals management’s
confidence in the company and leads to less price discount due to asymmetric information.

The convertible bond issue can be regarded as a contingent issue of equity. If a company’s
investment opportunity expands, its stock price is likely to increase, leading to conversion.
Thus the company gets fresh equity when it is most needed for expansion.

Small and growth firms are typically less known and have more expansion opportunities.
Therefore, it is not surprising to see they are the main issuers of convertible bonds. In
addition, the relatively low coupon rate on convertible bonds may also be attractive to small
growth firms facing heavy cash constraints.
Advantages and Disadvantages to Issuing Firms and Investors

In practice, there are a number of benefits for issuers and investors in convertible bonds.
There are, of course, downsides for both parties to consider.

Issuer
Advantages Disadvantages
 The company receives an upfront  The company is forward selling its
payment for ordinary shares to be issued ordinary shares through the equity call
at a later date, customarily at a premium option, which, if exercised, will lead to
to their market price. To the extent that a dilution of existing shareholders’ sakes in
company considers its ordinary shares to the company – this may be a sensitive
be undervalued at the time of pricing of area from a relationship perspective for
the bonds, the issue of convertible bonds the company and put downward pressure
may be an attractive alternative to issuing on the company’s share price. In the
ordinary shares. extreme, the dilution can challenge the
control over ownership. (See Case #2)
 Investors will accept a lower interest rate
on convertible bonds than plain vanilla  The ordinary shares of the company may
bonds, given the additional value of the not perform during the life of the bonds.
equity call option – this will be helpful In this case, holders of the bonds may not
for a company seeking to manage its debt exercise their conversion rights, and the
service and leverage ratios better. (See company will be forced to pay interest on
Case #1) the bonds during their entire tenor and, on
their final maturity date, return principal
 If the price of the company’s ordinary through new financing or available cash.
shares increases above the conversion (See Case #3)
price, the bonds will convert into
ordinary shares, and the company will not  The hedging strategies of certain
need to repay its borrowings. investors may lead to downward pressure
on the company’s ordinary shares, as
 The company is provided with access to a some investors that purchase the
broader investor base, as convertible convertible bonds may “short” the
bond investors consist of both hedge ordinary shares to hedge their respective
funds and “long-only” equity investors. positions.
 Investor
Advantages Disadvantages
 Irrespective of the performance of the  If the ordinary shares of the company do
ordinary shares of the company, the not perform, the investor will have
bonds continue to provide a fixed rate of achieved a poor return on its investment
income for investors through the coupon, (represented by the lower coupon payable
and a protected return of principal on on convertible bonds as against the
their final maturity date. coupon payable on plain vanilla bonds of
a similar credit) as at the final maturity
 If the company were to become insolvent date. This opportunity cost may be
or be liquidated, an investment in partially offset by gains made by shorting
convertible bonds would have even the ordinary shares.
ranked with the company’s unsecured
debt and ranked ahead of an investment  The value of convertible bonds can be
in the ordinary shares of the company in eroded by corporate actions taken by the
insolvency proceedings. company or negative events which occur
in the life of its business. While
 The investor has, as mentioned above, customary protections are contained in
upside participation in the performance of the terms of convertible bonds; it is not
the ordinary shares of the ordinary shares possible to protect the investor from all
of the company, as its option to convert events which might erode the value of
its holding of the bonds into ordinary their convertible bonds.
shares is set at a fixed price, and the
holder of the bonds, therefore, benefits
from any increase in the market value of
the ordinary shares above that fixed
conversion price.

Hong Kong Examples

Case #1

In May 2011, The Wharf (Holdings) Ltd 九龍倉集團 (0004.HK) issued a 3-year convertible
bond of 2.3% coupon, with a conversion price of HK$ 90 (about 60% premium of current
market price). The issuance has raised HK$ 6.2 billion to finance Hong Kong and China’s
properties development. The low interest cost – in comparison to the funding cost of Chinese
real estate companies that over 10% – is a favorable financing method.
Case #2

In 2010, Huang Guangyu 黃 光 裕 , a major shareholder of Gome Electrical Appliances

Holding Ltd 國美電器 (0493.HK) persuaded shareholders to dismiss Chen Xiao 陳曉, the
chairperson, and overturn the management board of the firm. Before the shareholders’
meeting, Bain Capital, who was in favor of the management, converted Gome’s convertible
bond (matured in 2016) at the conversion price of $1.108 into 1.6 billion shares. This move
made Bain Capital own 11% of company shares, and become the second largest shareholder.
Eventually, the motion of dismissal was overruled by a 3% difference.

Case #3

Convertible bondholders have the right to convert the bond into shares if share price exceeds
conversion price, otherwise, they continue to receive a fixed rate of income through the
coupon, and a protected return of principal on the final maturity date. Fu Ji Food and
Catering Services Holdings Limited 福 記 食 品 (1175.HK) issued convertible bonds to
finance their expansion when the market is good. And upon maturity, the firm issued a new
batch of convertible bonds to roll-over the old bonds. The idea of “financing circulation”
eventually broke down in 2008. The plummet in share price and the tightening of credit
made Fu Ji unable to issue another convertible bond or borrow from a bank to repay the old
bonds. Fu Ji eventually liquidated in 2009.