Updated July 10, 2023
What are Convertible Securities?
The term “convertible securities” refers to financial securities that can convert from one form (bonds or preferred stocks) to another form (common equity shares).
Usually, the organizations issue convertible securities to raise funds for specific business purposes. In some cases, the issuing entity reserves the right to call the securities prematurely at their discretion, while others offer put options to the holders of the securities.
Explanation
Convertible securities are debt instruments that offer investors the flexibility to exchange bonds or preferred stocks for a pre-determined number of common equity shares in the issuing company. Hence, convertible securities are considered to be hybrid securities that possess the features of debt and equity.
Features of Convertible Securities
Different features are as follows :
- Conversion price: The pre-determined price per share at which the convertible securities can be exchanged for the equity shares.
- The conversion ratio: It is the equity shares the investors will receive for each convertible security.
- Conversion premium: It is the difference between the convertible security’s market value and its par value.
- Call features: It represents the ability of the issuing entity to call the securities before their redemption.
- Put features: It represents the ability of the investors to redeem the securities before their scheduled maturity.
How do Convertible Securities Work?
Generally, convertible securities offer a slightly lower return than those without the conversion feature. The investors’ willingness to accept a lower payout is the potential profit that can be earned regarding stock price appreciation through the conversion feature. The pre-set conversion price is usually fixed at a price higher than the underlying stock’s current price. However, the stock price is likely to grow over the period. Therefore, the stock price might reach significantly higher by the time the conversion takes place than the pre-set conversion price. Thus the investors can earn additional profit from the stock price appreciation.
Examples of Convertible Securities
Different examples are as follows :
Example #1
Let us assume that XYZ Inc. has issued 10-year $1,000 par value bonds at a 6% coupon rate. The bonds can be converted into common stock at a conversion ratios of 50. Determine the conversion price of the convertible bond based on the given information.
Solution:
- Given, Par value = $1,000
- Conversion ratio = 50
Now, the conversion price of the convertible bond can calculate as,
Conversion Price = Par Value / Conversion Ratio
- Conversion Price = $1,000 / 50
- Conversion Price = $20
So, at the time of conversion, each convertible bond can be exchanged for 50 common equity shares priced at $20 each.
Example #2
Let us assume that ABC Inc. has issued 20-year $1,000 par value bonds at a 5% coupon rate. Each bond can be converted into equity shares at a conversion rate 40. Determine the profit earned in stock appreciation through the conversion feature of the bonds if the stocks of ABC Inc. trade at $35 at the time of conversion.
Solution:
- Given, Par value = $1,000
- Conversion ratio = 40
- Share price at the time of conversion = $35
Now, the conversion price of the convertible bond can calculate as,
Conversion Price = Par Value / Conversion Ratio
- Conversion Price = $1,000 / 40
- Conversion Price = $25
Again, the profit earned in stock appreciation through the conversion feature can be calculated as,
Profit = (Share Price at The Time of Conversion / Conversion Price – 1) * 100%
- Profit = ($35 / $25 – 1) * 100%
- Profit = 40%
So, the investor can earn an additional profit of 40% through stock price appreciation, which is over and above the 5% coupon rate earned on the bond before the conversion.
Types of Convertible Securities
There are two major types of convertible securities – convertible bonds and convertible preferred stocks.
- Convertible bonds: These debt instruments can convert into equity shares of the issuing entity before or at maturity. Hence, convertible bonds exhibit features of both debt and equity.
- Convertible preferred stocks: These preferred stocks are paid dividends at a fixed rate, and additionally, they have the flexibility to convert into equity shares of the issuing entity.
Who Should Invest in Convertible Securities?
Convertible securities are considered a good investment option for investors who can afford to wait for a long period until the maturity of the securities. Typically, companies with high growth potential offer these securities but require funds to crystallize the growth plans. However, the investors should study and understand the market the issuing entity operates in before making the investment decision.
Applications
Entities issue convertible securities for specific business reasons. Additionally, these entities don’t have easy access to traditional forms of financing, such as bank financing and a public offering. Thus, the companies issued convertible securities at a slightly lower coupon rate.
Advantages of Convertible Securities
Some of the major advantages are as follows:
- It allows the holders of the securities easy and hassle-free convertibility to equity shares of the issuing company.
- The investors can also earn higher returns if the stock price of the issuing entity exceeds the conversion price by a significant margin at the time of conversion.
- The interest earned on some convertible securities is eligible for tax deductions. However, the tax benefits might not be available after the conversion.
Disadvantages of Convertible Securities
Some of the major disadvantages are as follows:
- Due to the dilution effect, the issuing company’s earnings per share (EPS) decreases during conversion.
- It also results in the dilution of ownership due to adding new shareholders.
Conclusion
So, convertible securities are financial instruments that have the option to be converted into equity shares. On average, these securities are beneficial for both investors and issuers. However, investors should ensure that they understand the terms and conditions of the issue before they start investing in these securities.
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