Why Convertible Bonds Can Be Very Expensive

One popular way for high-growth companies to raise money is by issuing convertible bonds. Convertible bonds allow holders to convert their bonds into stock at a specified price, thus participating in some of the upside of the company. As a result, convertible bonds carry lower interest rates than traditional bonds.

Companies such as Tesla Motors and Netflix have used convertible bonds to finance growth while paying very low interest rates. Convertible bond fans find these interest rates very enticing, and argue that businesses should issue convertible bonds more frequently.

From this perspective, convertible bonds are a much more dubious financial instrument. If you think a stock could be a multibagger, then you don't want the company to sell shares -- even at a 50% premium to the current stock price. A look at how convertible bonds work in practice will show how much this can hurt.

Convertible notes in practice: Tesla Motors

Tesla has issued convertible bonds twice in the past year and a half. By doing so, it has used its surging stock price to help finance growth projects such as research and development for new vehicles, expanding its vehicle factory in Fremont, California, and building a battery "Gigafactory" to support higher sales volumes in the future.

Tesla is paying rock-bottom interest rates on its convertible debt, as bond investors have been willing to sacrifice yield to capture some of the upside from Tesla's growth. Earlier this year, it issued five-year convertible notes with a 0.25% interest rate and seven-year convertible notes with a 1.25% interest rate.

Tesla has created a helpful table for investors to show the long-term dilution that could occur from its convertible notes after accounting for related hedge and warrant transactions. At Tesla's recent stock price of about $240 per share, the company would have to issue 1.2 million shares at maturity. That would represent about 1% of its current share count (125 million shares).

At Tesla's all-time-high stock price reached earlier this year, the dilution was closer to 2 million shares. If Tesla's share price reaches $600 by the time of maturity, dilution would rise to 4.3 million shares. Dilution would be even higher if the share price exceeds $600.

Today, the chance of Tesla stock flying past $600 might seem far-fetched. But at Tesla's IPO in 2010, the stock was valued at just $17. Early investors have achieved a 10-bagger in less than five years. The stock price has tripled just since the automaker issued its first convertible bond last year.

Tesla Motors Stock Chart, data by YCharts .

If -- as bulls believe -- Tesla is disrupting the auto market and will lead an industrywide shift to electric vehicles, it wouldn't be all that surprising to see the stock hit $1,000 by the end of the decade.

In that scenario, investors probably wouldn't complain too much about losing $60 to $70 of upside to dilution related to Tesla's convertible bonds. But it would still be a real loss. Tesla would end up giving away more than $7 billion in stock to save less than $1 billion in interest.

Making it real

The cost to investors of Tesla's convertible bonds is hard to specify today because the stock has risen so rapidly in the last couple of years and the bonds don't begin to mature until 2018. So let's look at another convertible bond issuer that will face shareholder dilution much sooner: Hawaiian Holdings .

In early 2011, Hawaiian Holdings (which operates Hawaiian Airlines) issued an $86.25 million convertible bond to finance an aggressive growth strategy. Two of Hawaiian Airlines' competitors folded in 2008, and several others downsized their operations. Hawaiian saw this vacuum as a big opportunity as travel demand rebounded following the Great Recession.

Hawaiian Holdings' stock traded for $6.11 at the time that the company issued the bond. Including the impact of hedges and warrants, Hawaiian Holdings won't have to issue any new stock unless the share price exceeds $10 in 2016. Yet Hawaiian's stock price has tripled since early 2011, surpassing $18 recently.

Hawaiian Airlines 5-Year Stock Chart, data by YCharts .

If Hawaiian's stock rises to $20 by 2016, the company will end up issuing nearly 5.5 million shares, worth about $109 million. If the stock reaches $30 by 2016 -- which is very plausible, given that Hawaiian still trades for just 10 times projected 2015 earnings per share -- Hawaiian would have to issue more than 7 million shares, worth $218 million, giving warrant holders more than 10% of the company's stock.

What did Hawaiian Holdings get in return? It issued debt with a 5% interest rate despite having a poor credit rating. If it had instead paid a 10% to 12% rate on nonconvertible debt, the additional interest payments would have totaled about $5 million annually (a little more than $3 million after taxes). In retrospect, that would have been a much better deal for shareholders.

Do you believe in your growth stocks?

The nice thing about convertible bonds is that they only hurt shareholders if the stock price soars between the time the bond is issued and when it matures. In other words, investors will already have done so well that they might not begrudge giving a share of the profit to convertible-note holders.

However, it's still a missed opportunity. If you are truly convinced about a growth company's prospects, then you shouldn't want the management team to issue convertible debt unless it has no alternative. If you think a five- or 10-bagger is in the cards, it's no consolation that the dilution won't begin until the stock rises 50%.

Convertible debt can save growth companies money in the short term by lowering interest expenses. But investors shouldn't ignore the significant long-term cost of convertible debt: the risk of giving up 5%, 10%, or even more of the upside from a great company.

The article Why Convertible Bonds Can Be Very Expensive originally appeared on Fool.com.

Adam Levine-Weinberg owns shares of Hawaiian Holdings and is short shares of Netflix. The Motley Fool recommends and owns shares of Netflix and Tesla Motors. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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