The Cons of Convertible Bond Investing

When markets are volatile, investors love a good hybrid security. Give them the stability of debt and the potential upside of equity, and they tend to feel a lot better about handing over their money to growing companies-which explains why convertible bonds had another great year in 2003. The amount raised in new convertible bonds-$85.6 billion-was the second highest in history, according to a December 2003 Morgan Stanley research report.

In 2003, smaller companies in particular benefited from the surge in convertible activity. According to the report, the percentage of convertible new issues from small-cap companies increased dramatically-from 46.7 percent of the total in 2002 to 63.9 percent in 2003-while the percentage of new issues from S&P 500 companies fell to 24.1 percent from 42.8 percent. Convertible bonds are essentially debt with a twist: In addition to getting steady interest income, the investor has the option to convert the debt to equity by buying the company's stock at a fixed price in the future.

And in exchange for offering future equity, the company gets to pay a lower interest rate for a convertible than it would for any other kind of straight debt. That makes it a solid option for raising cash when bank doors are shut and equity markets remain sketchy. But experts advise that entrepreneurs should proceed with caution on convertible deals; there's a reason they're known for being an excellent investment vehicle. "It gives a lot of power to the investor," says Tom Taulli, an attorney and angel investor who teaches mergers and acquisitions at University of Southern California's Marshall School of Business. "Warren Buffett made himself the second richest person in the United States" thanks in part to convertibles, adds Taulli. "That's his preferred method of investing."

But the more power investors have, the less the company has; and savvy investors will try to dictate terms favorable to themselves, including a shorter time horizon, prepaid interest, tough penalties for missed interest payments, or the option to lower the conversion price threshold if the stock price depreciates significantly. "The fine print is so critical," says Taulli, "and you really need to have a qualified expert, usually an attorney, who specializes in these kinds of financings to make sure you're not giving away the store."

The catch for smaller companies is that they can't always predict their future cash flow, which can make the convertible bond a dangerous option, says Jim Alterbaum, a corporate attorney with Jenkens & Gilchrist Parker Chapin LLP in New York City. "Because, like any debt instrument, it requires payment," he says, "and if there's a default on an instrument like this, not only does it put the company at risk, but it could also create defaults on other documents."

In other words, a default on a convertible could trigger default on a bank note. If the company isn't positive it can meet its obligations, it should try to negotiate certain terms of the deal. For example, if the short-term payments are going to be a problem, try to get the investor to take additional equity instead of a dividend, says Alterbaum, though he adds there are tax implications for all the variations, so an expert should be consulted.

Another important consideration is that underlying the convertible is the promise of conversion to stock. "If for some reason the stock goes down or is delisted, that will [mean] the company has to pay the bond off in total," says Nandkumar Nayar, a professor of finance at Lehigh University in Bethlehem, Pennsylvania. That, in turn, can trigger bankruptcy if the company does not have the assets to pay off the bond. And if the business owner used personal assets as a guarantee, the results can be devastating.

Taulli advises extreme caution when considering whether to do personal guarantees. "Be very realistic, and assume the worst. If you're willing to lose your home or your 401(k) or whatever assets you have, then that's no problem," says Taulli. "But if that's not a good feeling [for you], don't do it."

C.J. Prince is executive editor of CEO Magazine. She can be reached at cjprince@chiefexecutive.net.