Hung convertibles are a type of convertible security where the stock price of the underlying asset trades significantly below the conversion price, making the conversion into common stock highly unlikely. These securities present unique considerations for both investors and issuing companies due to their distinct pricing dynamics and investment implications.
Characteristics of Hung Convertibles
Conversion Price and Share Price
The conversion price is the predetermined price at which the convertible security can be exchanged for common stock. When the trading price of the common stock is far below the conversion price, the security is said to be “hung.” Due to this substantial gap, the likelihood of the security being converted into stock diminishes.
Impact on Investors
Investors holding hung convertibles may face lower returns compared to those holding straight debt or equity, as the anticipated benefits of conversion seem unattainable. They often rely on the interest or dividend payments provided by the convertible bond or preferred stock without the added benefit of conversion at a profit.
Impact on Issuers
For issuing companies, hung convertibles can be a double-edged sword:
- No Dilution Impact: Since conversion to equity is improbable, issuing companies do not face dilution of their existing shares.
- Interest Payments: Companies must continue making interest payments on these instruments, which can be a financial burden.
Types of Convertible Securities
Convertible Bonds
Convertible bonds are debt instruments that can be converted into a predetermined number of common shares. Hung convertible bonds continue to act primarily as regular bonds with periodic interest payments owing to the unattractiveness of conversion.
Convertible Preferred Stock
Convertible preferred stock can be converted into a specific number of common shares. In the case of hung convertibles, the preferred stockholder does not exercise the conversion option and remains content with preferential dividend payments.
Historical Context
Hung convertibles became noticeably significant during market downturns, such as the financial crisis of 2007-2008, where many convertible securities traded well below their conversion prices due to plummeting stock prices.
Special Considerations
Strategic Decisions by Issuers
Issuers might repurchase hung convertibles to improve their balance sheets or offer incentives for conversion to restructure their capital efficiently.
Market Conditions
The probability of a convertible becoming “hung” increases during volatile or bearish market conditions where stock prices can suffer steep declines.
Example Scenario
Consider a convertible bond with a conversion price of $50. If the stock price falls to $25, the bond is unlikely to be converted. Thus, it becomes a hung convertible, as investors are better off holding the bond rather than converting it into stock.
Comparisons and Related Terms
- Convertible Bond: A bond that can be converted into a fixed number of shares of the issuing company.
- Convertible Preferred Stock: Preferred stock that can be converted into a specified number of shares of the issuing company’s common stock.
- Conversion Ratio: The number of shares an investor receives upon converting the convertible security.
- Dilutive Securities: Financial instruments that can be converted to common stock, potentially increasing the total number of shares outstanding.
FAQs
What makes a convertible security 'hung'?
Can hung convertibles become regular convertibles again?
Why would an investor buy a hung convertible?
Do hung convertibles affect financial statements?
References
- “Convertible Securities.” Investopedia. [link]
- “Understanding Convertible Bonds.” The Motley Fool. [link]
- “Market Dynamics of Convertible Bonds.” CFA Institute. [link]
Summary
Hung convertibles represent a niche category of convertible securities where the conversion to common stock is impractical due to significantly low stock prices. They pose specific advantages and challenges for both investors and issuing companies. While investors benefit from fixed income yields, issuers avoid equity dilution but must manage the continued financial obligations tied to these instruments. Understanding the intricate dynamics of hung convertibles aids in making informed investment and strategic decisions.
