Convertibles are a unique category of corporate securities, typically in the form of bonds or preferred shares, that can be exchanged for a predetermined number of another type of security, usually common shares, at a specified price.
Definition and Types of Convertibles
Convertibles are hybrid financial instruments that combine features of both debt and equity. They provide investors with a fixed income security that comes with the option to convert into equity, offering potential for capital appreciation. There are several types of convertibles, such as convertible bonds, convertible preferred shares, and mandatory convertibles.
Convertible Bonds
Convertible bonds are corporate debt securities that can be converted into a specified number of common shares of the issuing company. These bonds usually offer lower interest rates compared to regular bonds due to the added conversion feature.
Convertible Preferred Shares
Convertible preferred shares are a type of preferred stock that can be converted into a set number of common shares. They typically offer a fixed dividend, and the conversion feature provides potential for upside capital gain.
Mandatory Convertibles
Mandatory convertibles are required to be converted into common stock at a predetermined time and at a specific rate. Until the conversion, they act similarly to convertible bonds and preferred shares.
Key Features of Convertibles
Conversion Ratio and Price
The conversion ratio determines the number of common shares an investor receives for each convertible security they hold. The conversion is triggered at the conversion price, a pre-stated price at which the transition from convertible security to common share occurs.
Benefits and Risks
Benefits
- Potential Upside: Investors benefit from potential share price appreciation.
- Fixed Income: Convertibles provide regular fixed income until conversion.
- Conversion Flexibility: Investors can choose when to convert based on market conditions.
Risks
- Interest Rate Risk: Convertible bonds are susceptible to interest rate fluctuations.
- Equity Market Risk: The value of convertibles is correlated with the underlying stock.
- Conversion Timing: Investors face the risk of poor timing in conversion which might lead to lower returns.
Example
Consider a convertible bond with a face value of $1,000, a conversion ratio of 40, and an underlying stock price of $20 per share. The bondholder can convert their bond into 40 shares of common stock at any time.
Historical Context
Convertibles have witnessed various phases of popularity, often peaking during times of low-interest rates and favorable equity markets. Historically, technology and biotech firms have utilized convertibles to raise capital while minimizing immediate dilution of equity.
Applicability in Modern Finance
Convertibles serve as valuable tools in capital restructuring and serve corporates and investors by providing a balance between risk and reward. Their flexibility makes them attractive during volatile market periods and for companies in growth phases.
Comparisons and Related Terms
- Convertible Arbitrage: An investment strategy involving buying convertibles and short-selling the underlying stock.
- Warrants: Long-term options issued by a company that give holders the right to purchase stock at a specific price.
- Options: Derivatives giving the right, not the obligation, to buy or sell an asset at a given price before expiration.
FAQs about Convertibles
What determines the conversion price?
The issuing company specifies the conversion price, usually based on the common stock’s market price at issuance with a premium.
Can convertibles be called by the issuer?
Yes, some convertibles come with a call provision allowing the issuer to force conversion under favorable terms.
Are convertibles good for all investors?
Convertibles are suitable for investors seeking income with the potential for equity upside but may not be ideal for pure fixed-income investors due to equity exposure.
References
- Bodie, Zvi, et al. “Investments.” McGraw-Hill Education, 2014.
- Fabozzi, Frank J. “Bond Markets, Analysis, and Strategies.” Pearson Education, 2016.
Summary
Convertibles are versatile financial instruments combining the features of debt and equity. They provide fixed income until conversion and potential for capital appreciation, making them attractive to a wide range of investors. Understanding their structure, benefits, and risks is crucial for making informed investment decisions.
By blending the stability of bonds with the potential upside of stocks, convertibles offer a unique investment vehicle in modern financial markets.
