After years of historically low interest rates, CFOs are now dealing with higher capital costs as central banks have raised rates to manage inflation. As companies look to raise capital or refinance debt in a significantly higher rate environment, many are searching for options that mitigate or eliminate the potential jump in interest expense. One option more companies are considering is convertible debt.

The ability to realize significant cash savings while effectively selling equity at a material premium has become a viable financing solution for companies that have experience with these securities. Additionally, a new cohort of prospective issuers – traditional debt issuers whose cost of financing has become less tenable – is taking a closer look at the convertible market than in past cycles.

While convertible debt may eventually convert to equity, thus becoming a higher cost security, there are other features that have made convertible debt a compelling financing option. These include a lack of covenants, no requirement for ratings and the ability to settle conversions at maturity in cash, shares, or a mix at no cost to the issuer.

Considerations before choosing convertible debt

There are both quantitative and qualitative tradeoffs to convertible debt securities and CFOs should consider a few factors while evaluating the pros and cons of raising capital with this product.

Cash cost – The primary rationale for many companies considering this security is simply the cash coupon savings available compared with the cost of debt on their balance sheet and/or available to them in the new issue market. It is not uncommon for companies to save 500–700 basis points or more per year by issuing convertible debt instead of term loans or bonds.

One recent example of a company taking advantage of this market dynamic was medical device company Integer Holdings, which recently raised US$500m to pay down higher cost debt in their capital structure. This transaction allowed the issuer to improve earnings and cash flow in real time. Integer was a first-time issuer in this market and had not previously considered the security but took advantage of market conditions to opportunistically reset its capital structure and financial profile. Other companies have already followed suit, with more on the way.

Capital structure flexibility – Another attractive feature of convertible debt is the inherent flexibility it provides companies, particularly in a volatile macroeconomic environment. Convertibles do not have covenants and are generally more junior in the capital structure, allowing issuers to preserve senior debt capacity. Additionally, the lower convertible coupon will be less impactful to any covenants a company may already be subject to. Further, convertibles can be structured with settlement flexibility. If the stock price is above the conversion price at maturity, issuers can retain the option of settling conversions with cash, shares, or a mix, an option that may provide valuable capital structure flexibility in the future.

Benefits of a call spread – One of the primary concerns leaders highlight when considering convertible debt is the risk of dilution if the stock price exceeds the conversion price. Call spread overlays are not new to the convertible market but may take on added importance for certain prospective issuers considering a transaction. Call spreads allow the issuer to synthetically increase the effective conversion price in the convertible to a much higher level (e.g., from a premium of up 30% to up 75%–100%), creating a security with a cost of capital profile closer to straight debt. With many stock prices trading at depreciated levels, increasing the effective conversion price on a convertible can make a security palatable that otherwise might not resonate with management or investors. Additionally, the mechanics of call spread execution provide technical support during the marketing of the convertible that can positively impact stock price performance and provide the issuer with incremental additional value.

Transaction execution details matter – The cost of capital in a convertible deal is driven in part by the level at which investors can convert their security into equity. This price is determined by the closing stock price on the day of pricing, along with a conversion premium set by the market when deal terms are negotiated. Stock price risk can be easily overlooked, but materially impacts the value and ultimate cost of a deal. There is no foolproof way to predict or control stock price performance, but a few things to consider include the following:

• Deal size: Larger deals imply greater potential dilution. Upsizing into demand may prove more effective in some cases than going to market with a larger initial offering.

• Investor allocations and messaging: Carefully messaging allocation goals and order book strength is important to limit pressure on the stock price.

• Technical support during execution: A share repurchase, or a call spread, can offset selling pressure from arbitrageurs. Stock prices in convertible debt offerings with a call spread and/or share repurchase have performed 3%–5% better during the marketing period than in transactions without either.

In summary, the elevated interest rate environment has changed the way many issuers are funding their businesses. The cost of raising capital has dramatically increased in recent months, against a challenging business backdrop that is forcing many CFOs to think creatively about their capital structure. Convertible debt provides benefits and flexibility and we expect issuance in this market to pick up as current conditions are expected to persist.

For more resources and information on equity capital markets, visit Ernst & Young Capital Advisors, LLC Equity Capital Markets Advisory.

David A. Brown is Head of US Equity Capital Markets and Daniel Josephs is a managing director at Ernst & Young Capital Advisors, LLC.

The views reflected in this article are the views of the authors and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.