A convertible is a fixed-income security that gives the holder the right, but not the obligation, to convert it into a predetermined number of the issuer’s ordinary shares on a certain date or over a specific period, subject to meeting certain conditions.
The decision to convert is exclusively for the security holder. There is no obligation for the holder to convert, and they are likely to choose to convert into shares if, at maturity, the value of the shares they can convert into exceeds the redemption value of the fixed-income security. Similarly, the issuer may also have the right to call (i.e., redeem) the issue if certain conditions are met.
This characteristic of multiple embedded options can make evaluating convertibles difficult. A convertible is like a hybrid of a corporate bond and a warrant, with the difference that in the case of exercising a warrant, the holder will have to pay cash, whereas, with the convertible bond, the payment is just the forfeiture of the bond itself in return for shares.
The holder of a convertible has the safety of coupons and repayment, combined with the potential
the upside of equity growth.
Characteristics of Convertible Securities
Some of the essential characteristics of convertible securities are:
- Convertible securities pay a low coupon, offset by the option to convert into shares at the conversion date.
- Convertible securities are subordinated financial instruments, i.e., they require senior creditors to be paid out in full before any payment can be made to holders in the event of insolvency.
- These are considered both deferred shares and bonds. Deferred shares because issuers expect them to be converted into shares at the conversion date. Bonds because they could be converted to shares.
- Include rights typically to convert the debt into ordinary company shares in a predefined conversion ratio. For example, Rs 100 nominal is converted into 30 shares (a conversion ratio of 30). The conversion right may exist during the bond’s life (the conversion window) or may only be available on maturity.
Additional Terms in Convertible Securities
Convertible security has a range of conversion ratios that can be included at different maturities of the bond:
- The holder of the convertible bond could also be required to provide extra capital on the conversion, e.g., Rs 100 nominal of the debt converts into 20 shares, and the bondholder is required to pay an additional Rs 2.50 per share. So, each share has an actual cost (assuming the bond is trading at par) of (Rs 100 ÷ 20 = Rs 5) + Rs 2.50 = Rs 7.50.
- Put rights enabling the bondholder to force an early redemption of the bond, generally at a premium to the par value.
- Call rights enable the issuer to call the bond under certain conditions.
- When establishing the terms of the convertible, the issuer will usually avoid unnecessarily complicated terms since this will confuse and dissuade potential purchasers of the bond.
Conversion Price
The convertible’s conversion price is the effective price for conversion into the stock with the bond at par. At the time of issue, the offering prospectus indicates the common stock price equivalent to the value of the bond at par. This price, in turn, determines the number of shares of stock into which each bond at par can be converted; this is the conversion ratio.
Confusion often arises among investors because the conversion price is specified in the bond documents, but the conversion ratio is not; it must be calculated. The conversion price is meaningful only when the bond is at par, and it can be calculated by dividing the par value by the conversion price.
For example, if the common stock price at which the bond can be converted is Rs 50, then each convertible bond represents 20 shares of stock (par value of Rs 1,000 divided by stated conversion price of Rs 50 = 20).
What is the conversion ratio?
The conversion ratio determines the number of shares of common stock a convertible bondholder would receive if the bond were converted into stock. The conversion ratio is set at the security issuance and is typically protected against dilution. It may well specify partial shares also. (i.e., 15.5 shares).
Conversion Ratio = Par Value of a Bond / Conversion Price.
The conversion ratio is usually adjusted for stock splits and stock dividends. The initial conversion ratio in our example was 20 shares of stock per convertible bond. The conversion ratio would be adjusted to 22 following a 10% stock dividend.
Valuation of Convertibles
The valuation of convertibles presents the investor and the company issuing them with some complexities, as there are trade-offs between the various considerations involved. However, in terms of the initial pricing and placement of the issue, the simple rule of thumb is as follows:
- If it is too expensive, investors will not purchase the convertible stock, and the issue will fail.
- If the price is too low, the issuer will obtain finance on disadvantageous terms, affecting shareholders if the share price drops.
Valuing convertibles is complex in practice due to the various embedded options that may exist, but an assortment of models have been developed. Three of the most popular ones are;1) the dividend valuation model, 2) the crossover method, and 3) the option pricing method.
Advantages and Disadvantages of Convertible Securities
Advantages to the Issuer
Compared to both a bond and a share issue, convertibles offer the following advantages to the issuer:
- At the time of issue, there is no immediate dilution of the current shareholder’s rights.
- A lower coupon is payable than a typical, fixed-rate bond structure would be.
- Suitable when assets are not available to secure straight finance,
- Ideal for finance projects with long payback periods.
Disadvantages to the Issuer
- If the company fails to perform, it is still obliged to make the coupon payments and, ultimately, redeem the bond for cash if the holder chooses not to convert.
- A firm cannot be sure that it is issuing deferred share capital when issuing a convertible.
Advantages to the Investor
- The holder has the security of a fixed-income instrument, offering downside protection even if the shares fall in value and the opportunity to benefit if the shares perform well. However, as unsecured lower-ranking stock, this advantage could be limited in the event of, say, liquidation of the firm.
- Convertibles rank above shares in priority on liquidation.
- Convertibles usually offer higher yields than the underlying shares.
- Convertible bonds tend to be very marketable compared to non-convertible issues.
Disadvantages to the Investor
- Although potentially offering higher yields than the underlying shares, convertibles usually provide lower yields than equivalent straight bonds.
- The attractiveness of a convertible may be affected by issuer call options.
- If anticipated share growth is not achieved, the holder will have sacrificed yield for no benefit.
Benefits of Convertibles in a Diversified Portfolio
Diversification
Convertibles offer diversification along the lines of industry, style, and market capitalization. Convertibles can help to diversify an equity portfolio through their performance characteristics. In a falling stock market, the debt portion of the convertible typically cushions the effects of a market decline, often allowing convertibles the potential to outperform equities. In a rising stock market, convertibles provide the opportunity for capital growth.
Yield Potential
Compared with traditional equity securities, convertibles have provided the opportunity for higher yield potential. Also, unlike equity dividends, the convertible coupon (or dividend) is contractually guaranteed, providing investors with a more secure income stream.
Opportunity for Risk-adjusted Returns
While a convertible’s fixed income characteristics can help mitigate downside risk if the issuing company’s common stock performs poorly, the underlying equity option allows the holder to participate in a significant portion of the upside if the stock performs well. As a result, convertibles offer the potential for attractive risk-adjusted returns. Moreover, it has been observed in capital markets of various countries across the world that the performance of convertibles has been competitive, generally keeping pace with the performance of common stocks over the past 10 years.
Lower Principal Risk
Convertibles generally represent a lower level of principal risk than common stock since convertibles are more senior in the capital structure. In corporate bankruptcy, convertible holders are repaid ahead of common shareholders. Furthermore, convertibles historically have had a lower long-term default rate versus specific corporate credit markets like high-yield and leveraged loans.
Conclusion: Determining a Convertibles Allocation
Critical considerations for determining an allocation should include return and volatility expectations and understanding how a portfolio can benefit from adding convertibles in place of or complementary to another asset class, such as investment-grade or high-yield bonds or equities. At their most basic, convertible bonds provide a security blanket for investors who wish to participate in the growth of a particular company without all of the downside risk associated with equity investing. Holding convertible bonds also provides another way to diversify the fixed-income component of a fund or portfolio.