Jul. 20–Summer’s here and the time is right for corporate executives to zoom off in their shiny new convertibles.<\/p>\n
Not cars, silly — bonds. Bonds that can, in essence, be paid off with stock instead of cash.<\/p>\n
Like regular bonds, most convertible bonds pay a fixed interest rate. But they also give holders the option of trading the bond in for a set number of shares. Investors profit if the stock price rises above the conversion price; if the stock price falls, they get some interest income and their original investment back when the bond matures.<\/p>\n
With interest rates at 45-year lows and investors encouraged — but not entirely sure — that the stock market is coming out of its long swoon, demand for convertibles has risen sharply in the past few months.<\/p>\n
“When people are sort of anticipating that the market is more likely to go up than down, the option element becomes more valuable,” said Charles Haley, a finance professor at the University of Washington. “Investors say, ‘If the stock goes up I can participate, but if they don’t I’ve got some protection on the downside.'”<\/p>\n
Cash-hungry companies have noticed. Since the market hasn’t had much appetite for secondary stock offerings, a record number of companies have turned to convertibles.<\/p>\n
According to Thomson Financial, 100 U.S. companies sold $33.2 billion in convertibles in May and June — nearly as much as in the preceding six months combined.<\/p>\n
In the first half of the year, a dozen Northwest companies raised a total of more than $2.4 billion by selling convertibles.<\/p>\n
Nextel Partners is one of them. In May, the Kirkland-based wireless carrier said it would sell $100 million in convertible bonds; a few days later, the company boosted the deal to $150 million. Ultimately, Nextel sold $175 million worth of bonds.<\/p>\n
Nextel will pay just 1.5 percent interest on the convertible bonds, rather than the 2 to 2.5 percent its bankers at Morgan Stanley had originally predicted. Nextel is using most of the money, along with $450 million it raised by selling regular bonds, to retire older, higher-interest debt; it expects to save $30 million a year in interest payments that way, Chief Executive John Chappele said.<\/p>\n
Who’s buying convertibles? Mostly managers of hedge funds — those large investment pools that cater to rich, presumably sophisticated investors. Hedge funds use a range of complicated strategies to boost returns; the convertibility feature gives the funds even more flexibility.<\/p>\n
“Hedge-fund managers are clamoring for these securities,” said Richard Peterson, chief market strategist at Thomson Financial.<\/p>\n
Legendary investor Warren Buffett recently demonstrated the profit potential of convertibles.<\/p>\n
Last year, a group led by Buffett bought $500 million in convertible bonds from Level 3 Communications, a struggling Colorado broadband company. After Level 3 turned itself around, Buffett and brethren exercised the conversion option; their stake in the company is now worth nearly $900 million. The $34 million they received in interest payments was gravy.<\/p>\n
However, their hybrid nature makes valuing convertibles tricky. Depending on the level and direction of interest rates, conditions in the stock market, and the conversion terms, maturity and other peculiarities of each bond, convertibles may behave more like bonds (with a stock chaser) or stocks (with a bit of cash).<\/p>\n
“It’s a wild and woolly world,” Haley said.<\/p>\n
A small number of mutual funds invest exclusively in convertible securities. In the recently concluded second quarter, according to industry tracker Lipper, such funds gained an average of just over 10 percent — about midway between S&P 500 index funds and general corporate-bond funds.<\/p>\n
Because of their stock component, convertibles let companies borrow at lower rates than straight bonds. The 1.5 percent on Nextel’s new convertibles, for example, contrasts with the 8.5 percent it’s paying on its new straight bonds.<\/p>\n
But the tradeoff is the risk of dilution. When straight bonds are paid off, they go away. But when convertibles are traded in for stock, the company has to issue millions of new shares — and like a bartender watering down his good Scotch, all those new shares make the shares held by current shareholders worth proportionately less.<\/p>\n
Take Nextel. Its $175 million in convertible bonds is equivalent to more than 23 million shares; for a company with 172 million shares outstanding, that represents a substantial watering down of current investors’ stakes.<\/p>\n
That’s why Nextel didn’t try to raise all its money through convertibles, Chappele said — the company didn’t want to expose its shareholders to any more dilution than necessary.<\/p>\n
“You’re kind of walking a tightrope,” he said. “You take a little bit of dilution to strengthen your balance sheet by retiring debt.”<\/p>\n
To guard against dilution, some companies use part of their convertible proceeds to buy options on their own stock. That way, if a company has to issue a bunch of new stock to convertible holders, it can buy back an offsetting amount of existing stock at a preset price.<\/p>\n
Micron Technology, for example, spent $95 million of the $632.5 million it raised in its January convertible offering to buy stock options.<\/p>\n
Historically, economists say, convertible-bond issuers tended to be smaller, riskier companies, with favorable outlooks but volatile stock prices. But the recent surge has included old-economy companies such as truckmaker Navistar International and established businesses such as Computer Associates, the world’s fifth-largest software maker.<\/p>\n
Nonetheless, most convertible issuers look less like Navistar and more like Icos, the Bothell-based biotechnology company that recently sold $278.7 million in convertible debt.<\/p>\n
Mike Stein, Icos’ chief financial officer, said Icos needed money for the anticipated U.S. launch of Cialis, its Viagra-battling impotence drug. Since Icos has yet to turn a profit and has few tangible assets, Stein said, regular bonds weren’t an option.<\/p>\n
“With the expectation of a rising stock price, (the convertible issue) was the most cost-effective way of financing,” he said.<\/p>\n
However convertibles may look to companies and hedge funds, they may be yellow flags for ordinary investors. Economists have found repeatedly that stocks of convertible-issuing companies consistently underperform both their peers and the broader market.<\/p>\n
Interest in convertibles rises and falls, and some observers think the current boom may have already maxed out. With interest rates unlikely to fall any further and growing confidence in the overall economy, investors may decide they don’t need the added protection a convertible affords.<\/p>\n
“I’m very glad we went when we went,” Nextel’s Chappele said. “I think we hit it at its peak.”<\/p>\n
But Richard Nelson, who tracks the convertible market for Morgan Joseph, a New York-based investment bank, isn’t so sure.<\/p>\n
“I thought so last month, but I see a lot of small biotechs and pharmaceutical companies coming down” the convertible pipeline, Nelson said.<\/p>\n
“The conditions are still favorable, though things could change quickly,” he said. “I think the world has come to realize that the convertible is a good vehicle for raising capital, and is also a back-door vehicle for issuing stock.”<\/p>\n
COMING TO TERMS<\/p>\n
Bonds represent money loaned to the company. They come in two varieties: interest-bearing bonds, which pay interest periodically at a set rate until they’re redeemed, and zero-coupon bonds, which are sold at a discount to their full face value; the bondholder receives the face value when the bonds mature.<\/p>\n
Stocks represent an ownership stake in the company. Investors make money two ways: from dividends, which are paid at the discretion of the company’s board; and price appreciation (i.e., selling the stock for more than you bought it).<\/p>\n
Convertible bonds are stock-bond hybrids. Most of them pay interest (although some are zero-coupon), but they can also be converted into a given number of shares of stock. Investors can make money both from the interest and from the difference between the conversion price and the market price of the stock.<\/p>\n
—–<\/p>\n
To see more of The Seattle Times, or to subscribe to the newspaper, go to http:\/\/www.seattletimes.com.<\/p>\n
(c) 2003, The Seattle Times. Distributed by Knight Ridder\/Tribune Business News.<\/p>\n
TOC, NXTP, MWD, LVLT, NAV, ICOS,<\/p>\n","protected":false},"excerpt":{"rendered":"
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