Outlook: Convertible bonds

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IT IS hard to recall when conditions were so favourable to a revival in the corporate bond market as they are now. On cue, Railtrack has taken advantage as no other of historically low interest rates to launch a series of bond issues to finance its investment plans. Now it has come up with a bond issue with a difference - a convertible.

On the Continent, such convertible bond issues are common, but they are taking time to catch on in the UK - more than a half of yesterday's pounds 400m issue was sold to foreign investors. Nonetheless, there has been a steady stream of them in the past year from the National Grid, to Telewest and BAA.

Their appeal to issuers is twofold. Firstly, convertibles carry an exceptionally low coupon. In Railtrack's case this is just 3.5 per cent, some 2 percentage points lower than Railtrack would have to pay on a conventional ten year bond. This is even less than the Government pays for its ten year money. This is achieved by giving investors the right to convert their bonds into equity; in effect the investor trades in part of his coupon in return for the potential upside on the equity.

The second advantage is that to the extent that the investor does convert into equity, he has to do so at a big premium to the prevailing stock market price - in this case 25 per cent. It is not unknown to raise equity at a premium to the market price, but few companies find it easy.

So if these convertibles are so advantageous, why are so few British companies indulging in them? Unfortunately, only companies with exceptionally good credit ratings seem to be able to contemplate this method of capital raising - hence the line up so far, which reads like a roll call of former state monopolies, top drawer property companies and assorted steady revenue earners. For higher risk companies, such bond issues have proved either next to impossible, or prohibitively expensive.

This could change, however. As investors become more accustomed to this form of quasi-equity, it may be possible for smaller companies, with more volatile earnings streams, to tap into this market too. If that were to happen on any meaningful scale, it might provide a partial answer to the stock market's failure to deal with the capital needs of many smaller enterprises. A ten year bond convertible at a premium into equity would seem to provide just the sort of cheap long term capital many small companies crave.