Late in 2003, Wells Fargo, one of the nation’s top financial firms was considering their first issuance of convertible bonds. Even when this was not their usual way of financing and experts agreed that a top company like this one should not finance via convertible bonds, there could be a market opportunity. This case will explain the characteristics of convertible bonds and the strategies implied in them. We will also go into the specific case of this unique issuance, its pricing, value and Wells Fargo’s possible strategies.
Debt, Equity, Either, Neither
Convertible bonds operate as hybrid securities with both debt and equity features: the bondholders can convert the ...view middle of the document...
Facing different options of financing, a good, a bad, and a medium quality company would logically pick the instruments that would better match their position. For example, a “good” company that will bear no expected costs of financial distress with the issuance of debt should have no desire to issue equity (or an option on it). A “bad” company, on the other hand, would not want to issue new debt that would stress its financial position even more. Bad companies usually issue stock. Now, for a “medium” firm that wants to put equity into its balance without sending a negative signal to the market while managing the risk of financial distress brought about by issuing more debt, the Convertible bond is ideal. Basically, the issuance of a convertible bond signals that a medium quality company is optimistic on the price of its stock and will be able to generate equity while sending a positive signal to the market.
Wells Fargo is not your typical Convertible Bond issuer and that makes this issuance interesting. From a quality point of view, WF is a top tier financial firm, and thus, it is hard to argue that the issuance of a Convertible bond would be signaling improvement in the stock. Hence, this is an opportunistic issuance. WF management wanted to take advantage of inefficiencies excess demand has on instruments within the market. Taking the possibility of managing maturities and durations via hedging instruments and derivatives, any sweet spot in the market should generate more efficient funding opportunities. This is an interesting idea, but it has two underlying assumptions that may not always be true: 1) market efficiencies are common due to “trends” and 2) there will always be an efficient way to hedge this interest rate risk.
Regardless of theoretical opportunities, in 1998 WF issued $3 billion in convertible bonds, this were their characteristics and payoffs. Assuming Wells Fargo will not default (due to its rating), the payoff to a bondholder who invests in one convertible bond would be $1,000 for stocks prices below $100. Between $100 and $149.39 the payoff payments has a slope of 43.5 and above 149.39 the slope decreases to 21.1. On the other hand, the payoff to an investor who decides to invest $1000 in common stock at the current price of $47.5 (therefore buying 21.052 shares) would have a slope of 21.05. (Appendix 1)
The structure of payments of the convertible bond is the reflection of the two warrants embedded in the conversion bond. The first one, effective above $100, gives the bondholder a premium over the shareholders because they receive a higher slope than common shareholders (43.5 over 21.05). The second warrant operates as a cap to the profits of...