More companies than ever before are issuing convertible bonds as a way to raise capital. According to conventional wisdom, these hybrids — part bond, part stock — attract investors because they promise the security of a bond, plus the option to convert to equity should the company's market valuation rise. For the issuing company, convertibles require lower interest payments than do ordinary bonds — or, increasingly, no interest at all.
To finance professor Darrell Duffie, however, these explanations for convertibles' popularity do not make sense on their own. Since their advantages may already be priced-in through lower interest rates, convertibles may not actually represent a better investment than bonds or equities. "Among those who suggest that they really like convertible bonds, there's no one who says, convincingly, that he's getting a bargain when he buys them," he notes. As for the issuing company, the option component on the convertible means it may have to give away stock in the future, thus diluting earnings per share.
One intriguing theory is that the rise of convertibles is being fuelled partly by certain tax advantages. Two second-year Stanford MBA students, Jen Bergeron and Cheryl Frank, examined this tax incentive in a recent study done for a finance class co-taught by Duffie and Kenneth Singleton, the C.O.G. Miller Distinguished Professor of Finance.
The pair looked at the case of Alza, a pharmaceuticals firm based in Mountain View, California, which issued a 20-year convertible bond in 1994. Like many others, the Alza convertible includes a provision allowing the issuer to call the bond before maturity and thus force conversion. If the issuer exercises this call provision when the market price of its stock is rising well beyond the conversion price, investors would be virtually certain to opt for conversion into equity, rather than ask for their principal back.
Curiously, however, researchers have observed that firms often choose to keep their convertibles alive. This was the case with Alza. At the first call date, July 1999, the conversion price was $17.69, which was still higher than the prevailing stock price. However, from April 2000, the convertible was consistently in the money for more than a year: at its peak, Alza stock traded at 144 percent of the bond's conversion price. Yet, Alza did not exercise a call on the bonds.
Bergeron and Frank suggest that the most compelling reason is the tax shield provided by the bond. The bond promises a yield of 5.25 percent a year until maturity. Being a zero-interest bond, no annual coupons are actually paid out to investors. However, Alza's books must increment the value of its debt by 5.25 percent each year. The company can write off the year-to-year accretion value as an interest expense. Thus, in 2000, Alza expensed $22.7 million of interest on this debt. At a tax rate of 35 percent, it was able to retain almost $8 million in cash, shielding this amount from the taxman's grasp.
Of course, there is no guarantee that the bond will continue to be in the money indefinitely. The issuer must weigh the tax incentive for not calling the bond against the value of exterminating the convert option by calling it. In this case, it seemed the bond was so deeply in the money that Alza did not envisage much likelihood of ever having to pay out the cash representing the accrued interest; it has until 2014 to call the bonds, if investors do not convert them first.
What about the tax implications for the bondholders? The interest expense that is treated as a tax write-off by the issuer must be declared by investors as interest income — even though, in the case of zero-coupon bonds, this income is not realized in cash. Investors need to price-in this tax when buying the bonds. However, many buyers of convertibles are offshore, or otherwise tax-exempt, investors in hedge funds.
"It could be that convertibles have been so popular because their tax advantages are so distinct," Duffie muses. "In other words, the Internal Revenue Service may be subsidizing both the investors and the issuers of convertible debt."