What is a Floorless Bond?

Floorless Bond

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Floorless Bond

A floorless convertible bond, also known as a “death spiral convertible,” is a type of bond issued by companies to investors that can be converted into shares of the company’s stock at a discount to its current market price. The “floorless” term comes from the fact that there’s no floor or lower limit on the price at which the bond can be converted into shares.

Here’s how it works:

  • A company issues a convertible bond to raise capital.
  • The bond’s conversion feature allows bondholders to convert the bond into a specified number of shares of the company’s stock, typically at a discount to the stock’s current market price. This conversion can often be made at any time during the life of the bond.
  • The lower the company’s stock price goes, the more shares an investor gets upon conversion.

While this may seem like a good deal for the investor, it can be detrimental to the company and its existing shareholders. If the company’s stock price falls significantly, the conversion feature can lead to substantial dilution of the existing shareholders’ ownership stake.

Furthermore, it can create a “death spiral” effect: as the stock price falls, bondholders convert their bonds into more and more shares, which increases the supply of the stock on the market and can further drive down the stock price.

Due to these potentially harmful effects, floorless convertible bonds are generally considered a financing method of last resort for companies that may be in poor financial health and have difficulty accessing more traditional forms of financing.

Example of a Floorless Bond

Company XYZ is in poor financial health and needs to raise capital. Traditional lenders are unwilling to extend credit due to the company’s high risk. Therefore, the company decides to issue floorless convertible bonds to attract investors.

The bonds have a face value of $1,000 and can be converted into shares of the company’s stock at a 20% discount to the stock’s market price. An investor purchases one bond.

After some time, the company’s stock price falls to $10. The investor decides to convert the bond into shares. Due to the 20% discount, the investor can buy the shares for $8 each ($10 – 20%). Therefore, the bond is converted into 125 shares ($1,000 bond value / $8 discounted stock price).

If the stock price continues to fall, the conversion terms become even more favorable for the investor (and more dilutive for existing shareholders). For example, if the stock price falls to $5, new bond conversions would happen at $4 per share, resulting in 250 shares per bond.

The conversion of bonds into a large number of shares can lead to a significant increase in the supply of the company’s stock on the market, which can further drive down the stock price. This can lead to a “death spiral” of falling stock prices and increasing dilution of existing shareholders.

While this is a simplified example, it illustrates the potential risks and implications of floorless convertible bonds for the issuing company and its existing shareholders.

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