Explaining About The Varieties Of Debt

This is an overview of the varieties of debt, the way these loans are monitored and the convertion of shares to Cash and how companies repay their loans.

Jones Manufacturing’s sources of finance are also more varied and a little more complex than those of Smith & Co. There is a bank overdraft, though small in relation to the company’s size. But there are three types of medium term or long term debt under the heading of creditors due in more than one year. First comes the familiar term loan: again fairly small at £800,000. The other two items the debenture stock and the convertible loan stock are in a different category of borrowings, because they are securities issued by the company rather than loans from a bank. Much as the government does when it borrows by issuing a gilt edged stock, Jones Manufacturing has raised money by creating different forms of loan stock and selling them to investors: the familiar principle of issuing an ‘IOU’ note in return for cash. These stocks, once issued, will normally be traded in the stock market. Investors who paid cash to the company for them when first issued can either wait till the date they are due to be repaid by the company, or can sell them to other investors in the stock market. Both in this case pay a fixed rate of interest. The debenture stock will probably be secured on specific assets of the company. Provided the assets are of good quality, it should thus be a safe form of investment for buyers. It is a long term borrowing. It is not due for repayment until 2004, and when first issued it may have had a life of 25 or 30 years possibly more. The convertible loan stock is almost certainly an unsecured loan stock. It is not secured on the assets of the company, and to this extent it is a little less safe than the debenture. But its most important feature is that it is convertible. At some stage of its life, and probably right from the outset, it can be exe changed for ordinary shares according to a pre arranged formula. This gives it some of the attributes of a loan and some of the attributes of an ordinary share, though in legal and accounting terms it is a loan. Until it is converted, it pays a fixed rate of interest like the debenture stock. Once it is converted into ordinary shares, the shares are identical to the other shares in issue and receive the same dividend. If the stock is not converted into shares during the conversion period, it may revert to being a simple unsecured loan stock, paying the fixed rate of interest until it is eventually red paid in 2008. Whether or not holders of the stock exercise the right to convert it will depend on how successful Jones Manufacturing is. The conversion terms were probably pitched originally at a level somewhat above Jones Manufacturing’s share price at the time of issue the conversion premium. If the share price at the time had been 8Op, the terms of the loan might have stipulated that £1 nominal of the loan could be converted into one ordinary share, meaning that anyone who paid £100 for £100 nominal of the loan would be paying £1 for a share if he exercised his conversion rights. Five years later, if Jones had increased its profits and dividends at a good rate, the share price might have risen to, say, 180p. At this level there is clearly a value in the right to exchange £1 nominal of loan for a share worth l8Op. Because of this conversion value, the price of the convertible loan stock itself would have risen in the stock market. Investors would have been prepared to pay more than £100 for £100 nominal value of the loan, when they knew that each £1 nominal could be converted into a share worth 180p. The calculations that give the likely price of a convertible loan stock in the stock market, relative to the price of the ordinary shares, are quite complex. In general a convertible loan rises in value to reflect the rise in value of the ordinary shares, but rises at a slower percentage rate than the ordinary shares. On the other hand, it normally provides a higher and more secure yield than the ordinary shares, at least in the early years until the dividend on the ordinary shares catches up. For the company the main advantage of the convertible loan is that the interest rate it needs to pay will probably be lower than for an ordinary unsecured loan stock. Investors will accept the lower interest rate because of the possibility of capital gains if the share price rises and the market value of the convertible stock follows it. The convertible also represents a form of deferred equity. If the company had issued ordinary shares instead, its earnings and dividends would immediately be spread over a larger number of shares: the earnings would be diluted over the larger capital immediately. Convertible stocks with considerably more complex features are also commonplace nowadays, particularly in the case of issues made through euro market mechanisms and you find preference shares that are convertible into ordinary shares as well as loans that are convertible. One particular type of convertible needs mentioning here: the premium put convertible which also surfaced in an even more tortuous form as the convertible capital bond. The ‘premium put’ feature is an option for the investor which allows him to require the company to buy the stock back at a premium over its issue price after, typically, five years if the share price has not risen sufficiently to make conversion worthwhile. Take the example of a convertible capital bond issued by food group Sainsbury. The stock carried a low coupon of 5 percent. But the investor could sell it back to the company at £133.28 per £100 worth after five years to take his total annual return to 10.26 per cent. The conversion price into Sainsbury shares was 262p but effectively the Sainsbury price had to rise to 349p to make conversion a better option than selling the stock back to the company at £l33.28p for every £100 issued. As it happened, the Sainsbury share price rose rapidly and the stock was converted. Other companies such as the advertising group Saatchi & Saatchi found that a ‘premium put’ stock constituted a time bomb. If their trading fortunes turned down and the share price fell, investors would ask for the stock to be redeemed at a time when the company was least well placed to raise the money to redeem it.

The premium put feature appeals to euro market investors who are generally bond orientated rather than equity orientated. The disadvantage for the issuer is that he is not sure when issuing the stock whether he is raising permanent capital or whether he will have to find the money to redeem the issue at a premium after a few years.company, loans, premium