Dividend Protection

Dividend Protection

Prior to 2003, not many convertible bonds had dividend protection language. At best, they protected for only special dividends of over 10%. However, in 2003, the dividend taxation rules changed to favor stock dividends. To the extent that companies decided to increase dividends, this would negatively affect the valuations of most convertible securities.

To respond to these changes and their potentially negative impact, investment banks have structured dividend protection language as a means to offer protection against the value-deterioration.

Dividend protection is almost always provided by an adjustment to the conversion price or conversion ratio to convey the value of the distribution through the parity value of the bond. There are some instances where such protection could be provided simply passing through those dividend payments directly to bondholders in the form of cash.

Where to find the language:

Under Article Conversion, section Adjustment to Conversion Rate

This section will state the situations when an adjustment to the conversion rate will occur.
These usually include:

1)      Company issues a stock dividend or splits its stock

2)      Company distributes warrants or rights to stock holders (anti dilution provision)

3)      Company distributes assets or property to stock holders

4)      Company distributes a cash dividend (usually will only adjust for dividend above a certain threshold (typically the cash dividend at the time of issue)

Most of the time, there is a clause that says the adjustment will only be made if it is more than 1% in the conversion rate. If the adjustment is less than 1%, the dividend is carried forward to either conversion or the next adjustment period.

CSFB published a report on 8/26/03 titled, “Dividend Protection and Convertible Bonds” that explains this concept and is incorporated into this post.

CSFB believes the delivery of value through parity adjustment is more valuable than a simple cash pass-through. From the issuer’s standpoint, it saves them the cash outlay on the additional shares associated with the convert and should allow them the ability to garner a higher premium at issue. From the investor’s standpoint, the delivery of additional shares is a delivery of more optionality.

Theoretically, the bond becomes more valuable as the strike price on the convert is lowered which is offset by the expected fall in stock price. This works toward maintaining the value of the convertible bond investor’s position. We’d also point out that the majority of the existing protection language is asymmetrical—rewarding investors for dividend increases but having no effect on dividend decreases.

CSFB makes the following points:

• Conversion price versus conversion ratio. Really no surprises here but the language in the indentures of all dividend protected convertibles specifies a change to one of these two items. This is stylistic and should not represent a deterrent to any investor. Regardless of choice, the provision should have an expected impact, to either raise the conversion ratio or decrease the conversion price in the event of a dividend increase.

• The “fraction.” This is the actual multiplier used to calculate the change in either rate or price. This is typically some application of the market price of the stock and the dividend paid per share.

• Market price. Determination of the market price used to adjust the conversion ratio or price is important. It is usually an averaging period of varying length and typically on the closing sale price. The period for evaluation typically ends on the day prior to the record date for the distribution. Timing can affect the adjustment’s effect if the stock price moves materially ahead of the dividend record date. Some provisions afford management the ability to choose the period, giving a slight advantage to the issuer.

•Distribution calculation. Some protection language specifies that the cash distribution to be considered is simply the most recent payment. Others require the holder to utilize the trailing 12 months of distributions. Some use the total distribution. Others take only an amount exceeding a pre-defined level. These will affect your fraction and, ultimately, your adjustment. This is typically where protection language can be “diluted” to the extent that it allows the issuer to avoid having to make any adjustment on dividends that fail to meet the defined threshold.

• Overall thresholds. It is possible, although unlikely, that a particular distribution would pass the dividend threshold levels and not pass the overall test for conversion rate adjustment. The likely scenario where this could happen would be on dividend-paying stocks that will only adjust on excess amounts. However, it certainly is possible and this can further delay delivery of value to investors. Most conversion rate adjustment language requires at least a 1% change in the conversion price (conversion ratio) to be met to effect an adjustment. In most instances of dividend-protection language, distributions that fail to meet this larger test are “carried forward” to the next possible adjustment.

• Maximum or minimum adjustments. Some deals are structured such that the conversion rate cannot rise above a specified level or the conversion price cannot fall below a specified level. That level is usually the stock price at issue (adjusted for splits, etc.). This is usually a consideration made for the beneficial conversion option, which handles the scenario in which the effective conversion price makes the security appear as if it was issued in-the-money.