In my last piece I discussed the scarcity of investment-grade convertible bonds and those bonds’ tendency to trade at unattractive prices. I cited the bonds of
Indeed, buying investment-grade convertibles is often safe to the point of being dangerous. Now, I’ve become a far more cautious driver since I became a father, but few things irk me more than drivers who, even in ideal driving conditions, go substantially below the speed limit just to be “extra safe.” They’re actually endangering other drivers, of course, and so it goes with investors who pay up for the safety of scarce investment-grade convertibles. These investors are typically fiduciaries following rules that sound good (buy only safe companies) but consistently translate into poor investment performance.
While overvalued convertibles with poor risk/reward profiles most frequently carry investment-grade ratings, this is not always the case. An inspection of the 1.5% convertibles of Broadsoft Inc. reveals a speculative credit with a decidely inferior payoff structure.
First, compare the terms under which the bond was issued with its current trading price. Broadsoft, which makes voice-over Internet protocol (VOIP) software for telecommunications service providers (a lot to swallow, I know), has seen its stock decline from nearly $36 when it issued this convertible almost three years ago to about $27 now. That’s a 25% loss if you’re keeping score at home. Meanwhile, the convertible bond has risen from 100 to 104, paying a modest coupon along the way. So the convertible has done what it was supposed to do—and then some.
It’s the “then some” part that’s causing trouble. A more traditional and realistic performance from the convertible would have been participation in roughly a third of the stock’s decline, taking it down to around 93 or 94 cents on the dollar. With three years of coupons, holders would have sustained a small aggregate loss on the bonds, entirely appropriate for a stock that’s performed as weakly (in a powerful bull market, no less) as Broadsoft. But because convertible issuance has fallen far short of demand in recent years—a theme often discussed in this space—convertibles like Broadsoft have maintained their value substantially more than one would have predicted.
For this reason, I continue to sound a clarion call to prospective issuers of convertible bonds. Act now! Bonds like the Broadsoft convertible are only trading at these levels because of the supply/demand imbalance. If there really is an invisible hand out there, its index finger should be directing corporations—especially smaller ones unable to tap the bounty of a high-yield market that should be renamed “medium”-to raise money through convertible issuance before the opportunity disappears.
Back to Broadsoft. To illustrate the point, the bond was issued with a 1.5% coupon and a 17.50% conversion premium—a conversion price of $42, since the stock was nearly $36 when the bond was issued. That conversion price, mixed with the bond’s appreciation and the stock’s decline, means that convertible investors today are paying about a 60% premium. Theoretical models find the bonds roughly 10% overvalued today, consistent with the discussion above.
What does this mean for future performance? Well, let’s say the stock gains 50% over the next four years. Given the performance since 2011, that could be viewed as charitable, although perhaps the company is ready for a turnaround. The stock’s up so far today, after all.
Sadly, the unforgiving math of percentage gains and losses delivers grim news to today’s Broadsoft convertible holders. A 50% gain from last night’s close would get the stock just above $40, still $2 shy of the $42 conversion price. In other words, investors who pay 104 for the convertible today will actually lose four points if the stock appreciates by 50% from now until the 2018 maturity. Well, it’s not quite that bad—at least they will clip a 1.5% coupon annually.
Compare this with a 50% stock gain from the original terms of the bond. In that case, convertible holders would have made a 28% capital gain. Along with coupon income, they would have approximated the “two-thirds of the upside” mantra convertible proponents like this writer have been chanting for decades.
Not to complicate things too much, but the Broadsoft bonds also have a “provisional call” feature that limits holders from getting as much upside as they may expect, even if they think the stock will do substantially better than 50% from now to maturity. Put simply, unless Broadsoft shares really skyrocket over the next 15 months, convertible investors will probably be capped at a gain of around 40%. Admittedly, 40% sounds awfully good right now. But it may disappoint patient investors if the stock becomes a five or ten-bagger between 2015 and 2018.
The bottom line is actually one of those bold double lines accountants love. One of the lines cautions investors that convertible investing today is a bit like walking on the beach. You’ll find some gorgeous seashells, and maybe even some buried jewels, but you had better be extra careful for the dead jellyfish that can still sting. A lot of them have washed ashore in the aftermath of a zero-rate policy that has encouraged buyers but not issuers of convertibles. Past performance may not be indicative of future results, and if you don't know how convertibles work, your best course might be to follow Walter White's advice to his brother-in-law Hank, the DEA agent. Tread lightly. Spoiler alert: Hank didn't listen, and it didn't turn out well for him.
The second line goes out to issuers. In this case, Broadsoft. To review: three years ago, with its shares in the mid-30’s, the company issued a bond with a $42 conversion price. The stock is a lot lower today, but the bonds are higher. This suggests that Broadsoft could raise new money with the same coupon as before and a conversion price above $42—even with the stock’s decline. If this isn’t really the case—if Broadsoft couldn’t do that—then its existing bonds are far too high today. Either way, Broadsoft and companies like it need to explore convertible financings now, while the opportunity is clear and present.
A final note to prospective issuers: when Broadsoft issued this bond, it had been public for about a year. The company went public at $9 per share in June 2010 the stock stayed below that price the entire summer. Then things changed and shares got into the mid-40’s before slipping to the level from which the convertible was launched. If your stock has tripled or quadrupled over the past year, consider this story.
