Take the twist out of 'death spiral' convertibles

THE so-called "death spiral" convertible bonds that lie at the heart of the proxy battle at Magnus Energy may be a wake-up call for all stakeholders.

Regulators must ensure that the holders of such instruments are not skirting rules about control of a company; independent directors must ensure that disclosures to shareholders are explicit about the risks of such instruments and be transparent about why the bonds are necessary in the first place; and shareholders must learn to recognise death spiral convertibles as bad news.

What are death spiral convertibles? In a typical convertible, the conversion price is fixed, which means that the potential dilutive impact of the convertibles is known and limited. In death spiral convertibles, however, the conversion price is based on a formula that assures a discount to market. This not only protects the bondholder against a tanking stock price, but it also creates an increasingly dilutive effect with each round of conversion. When such convertibles are issued in large amounts by a company, or when the conversion prices are set at large discounts to market, the transactions can be devastating for the underlying stock price. Hence the "death spiral".