Rapid growth in capital bonds

By Peter V O'Brien

Friday 3rd May 2002

The search for efficient means of managing corporate debt has led to rapid growth in the capital bond market.

New bond issues are well ahead of convertible note offerings, although many companies carry convertibles on the books until the appropriate conversion date.

Others swapped convertible notes (which convert to shares) in favour of bonds, one being property group Trans Tasman Properties. The company's preliminary report for the year ended December said there was continuing uncertainty in the market about the real value of the notes due to their convertible nature.

"By exchanging the convertible capital notes for secured bonds, holders obtained a true debt instrument which is currently trading at close to its face value, something never evident in notes trading patterns."

Trans Tasman's situation differs from that applicable to other companies, because the group has been through tough times and is reorganising.

The broad principle regarding certainty of real value of convertible notes was valid.

A convertible note is a mixture of an interest-bearing debt security and an option to take up a share in the future, or get repayment of the notes' face value. The debt element should have a yield that varies as interest rates rise and fall but the capital element can confuse that.

Capital value will be related to movements in the head share price and subjected to fancy analytical calculations about effective income yields to conversion and a conversion value based on current prices.

Companies issued convertible securities in the past because they were seen as attractive to investors and useful for the issuer in raising debt funds with certainty of conversion to capital on a given date.

Capital bonds may outweigh convertibles from a company's viewpoint if the flexibility of the security is preferred to the benefits of convertibles.

The Stock Exchange lists capital bond securities of 19 companies, covering nearly 40 maturity dates. Relationship between the number of companies and the higher number of maturities is one clue to the popularity of capital bonds.

Another clue is the "election dates" in the securities' terms and conditions. That relates to flexibility, a point noted in Standard & Poor's comment in April when it gave energy distributor Powerco an A- credit rating after the company announced a proposed $100 million bond issue.

"The issue of the bonds enhances the company's capital structure and the bonds' features add a material level of flexibility to Powerco's long-term funding. Although the higher the cost of funding adversely affects cash flow, the improved flexibility more than compensates for that."

Retailer Arthur Barnett's Meridian Centre, owner of the Meridian centre in Dunedin, issued $22 million of capital bonds last year.

The Stock Exchange's formal description of the securities said they were fixed rate, unsecured, subordinated perpetual debt of an aggregate principal amount of $22 million. That meant they ranked below other debt but ahead of equity in a winding up or redemption situation.

Benefits of flexibility were seen in other conditions. The coupon rate was 10.5% a year until the first "election date" and would then be set 400 basis points above the four-year government stock yield.

The term "election date" related to the dates on which subscribers could elect repayment or the company could compulsorily redeem any amount of outstanding bonds on any election date. The first election date was October 15, 2005 and subsequent dates were October 15 on each fourth anniversary from the first date.

Meridian's $22 million issue was relatively small. Tower Corporation has finalised a $125 million issue, Powerco is after $100 million and other companies have had large bond issues.

Debt financing can be more complex. Dairy group Fonterra, which has quoted capital bonds, is seeking $US2 billion in euro medium term notes, $US1.5 billion of euro commercial paper and another $US1.5 billion in US securities.

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