As the name suggests, the convertible bonds and convertible preferred (or convertibles, in short) are securities that offer the holder the option of converting them into or exchanging with a predetermined number of common shares in the issuing company. They are hybrid securities that demonstrated the features of both equity and bond. Convertibles are issued by a company (also referred to as borrower) when a lower interest rate or dividend is desired and the issuer is willing to suffer the potential dilution of the investor converting the hybrid into common equity of the issuing company. Also, refer my article Equity: Common Stock, Preferred Stock and Convertible Preferred here.
Historically, the interest rates or dividend rates on convertibles have been lower than that of a similar non-convertible debt. The investor funds the company with the believe that the value of the underlying stock, into which the debt will convert, will grow over a period of time to an amount that exceeds a market rate of return for the instrument. In other words, the investor receives the potential upside of the conversion into common equity while protecting the downside with cash flow from the interest payments and the return of principal amount at maturity. However, if the stock delivers an under performance, the conversion does not make sense and the investor is stuck with a sub-par bond rate.
From the issuer’s perspective, the advantages of raising funds through convertibles are:
- reduced interest rates, and
- hybrids converting into common equity, whereby the company’s debt vanishes.
However, as mentioned above, the exchange for the benefit of reduced interest payments comes with the demerit of stock dilution.
A convertible bond can also be looked at as deferred equity. The debt instrument can be converted into common equity, thereby deferring the equity until the time when the conversion takes place.
The investor can choose to initiate the conversion or the issuing company can force the conversion. I’ll discuss this forced conversion in a moment.
Pricing strategies
In public companies, most of the transactions are structured as convertible preferred where the dividend rates are 3 – 4% lower than the rates otherwise available to the issuing company. For financially secured organizations, the share conversion price can be set at a premium of as high as 40% over its current market price. In other words, the company’s share price must increase by 40% before the investor would be excited to convert the hybrid into common equity.
Terms associated with convertibles
- Conversion ratio refers to the number of shares each security will convert into or exchanged with. For example, a conversion ratio of 30:1 means that each bond can be converted into 30 shares.
- Conversion premium signifies the amount by which the price of a convertible bond exceeds the market price of the common equity into which the hybrid can be converted.
- Conversion price is mentioned in the bond indenture (in case of convertible bonds) or in the security prospectus (in case of convertible preferred). Conversion price represents per share value at which the hybrid instrument will be converted into common equity.
- Call feature: A call is an option that gives the holder the right (not obligation) to buy a specified number of an underlying stock at a specified price within a given period of time. Convertible bonds carry a demerit with this call feature. The issuing company can “call” their bonds at any time, meaning they have the right to force convert the convertible bonds into common equity. Forced conversion usually happens when the price of their stock is higher than the amount it would be if the bonds were redeemed. The call feature puts a cap on the potential capital appreciation of the convertible bond. I’ll discuss more about how you can lose your money through a bond’s call feature in a separate blog.
Example
Now, let’s understand the entire concept with an example. Let’s assume that a public company issues $50 million, 5 years $1,000 convertible bonds that yield 6% interest rate and a 25% premium. This signifies that company will pay $3 million (6% of $50 million) annually as interest to the investor or $15 million ($3 million x 5 years) over the life of the convertible bond.
If the company stock was trading at $60 at the time of issuing the convertible bond, the investor would have the option of exchanging the instrument with common equity at $60 x 1.25 = $75 (25% premium). If the stock was trading at, say, $85 by the bond’s expiry date, then the $10 difference per share is the profit for the investor. However, a call feature is usually associated with a convertible bond to put a cap on the amount the stock can appreciate.
Alternatively, if the stock price plummets to $20, the bond holders would still receive the face value of $1,000 at maturity. This means that convertible bonds not only limit the risk of the investor when the stock price plummets, but also the exposure of the company to the upward price movement when the stock soars.
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