Convertible securities are investment instruments that are mostly issued by companies with an objective of raising funds to meet their business objectives. These instruments offer the unique features of both stocks and traditional fixed-income investments, thereby allowing investors to manage their risk and fetch higher returns. Similar to stocks, convertible securities tend to provide capital appreciation during rising equity markets and may not necessarily be impacted by rising interest rates. Similar to bonds, convertible securities offer stable income and possibly limited exposure to downsides of equity investments during declining market conditions.
What is a convertible bond?
A convertible bond is just like a corporate bond that can be converted into a fixed number of shares of common stock of the company that issued the bond. These are part of the debt instrument category since they pay interest to investors and come with a fixed maturity date.
Here are some of the noteworthy features of convertible bonds:
- Coupon or interest: Convertible bonds are considered secure investments since they offer a coupon or interest payment to investors. Thus, the interest rate offered and credit quality of the bond issuer will determine the value of such bonds and, therefore, the returns expected from the shares.
- Cost of conversion: Before investing in these, an investor must know the cost of conversion associated with such bonds. The net value at which an ordinary share is issued to an investor is called the cost of conversion. This is calculated using the book value of the stock, its market price, among other factors. Since the conversion price or cost of conversion is higher than a convertible bond’s price, an investor can earn good returns at the time of maturity of these instruments.
- Conversion ratio: Convertible bonds offer equity shares to investors at maturity. The number of such shares that one can receive against convertible bonds is termed as its conversion ratio. The issuer of the bond determines this ratio when selling the instruments to investors. While the value of convertible securities remains unaffected by this ratio, it impacts the total value of equity shares that an investor can get at maturity.
What is a convertible preferred stock?
Convertible preferred stock is part of a corporation’s capital stock and has characteristics that are similar to convertible bonds. A convertible preferred stock gives its owner the right to convert it into a specific number of equity shares of the underlying common stock at his/her discretion.
Here are its key features:
- Easy to convert: An investor can easily convert convertible preferred stocks into equity shares at maturity or at a time, as per the norms stated by the company.
- Assured dividend payout: These stocks offer assured dividend payouts since they are preferred shares and therefore come above common shares. In case of company liquidation, convertible preferred stocks get preference of repayment over other shareholders.
- Participation in management affairs : Investors of convertible preferred stock can enjoy participation in the company’s management, especially in case of financial distress. In real-life scenarios, stock market investors would know how Warren Buffett has utilised such investments to actively participate in various company’s operational nuances.
Why should investors buy convertible securities?
Here are some of the benefits that investors can fetch from investing in convertible securities:
1. Tax savings
Convertible securities are eligible for some tax benefits, including deduction of interest earnings from an investor’s total taxable income. However, once converted, these securities may not be eligible for tax benefits.
2. Hassle-free conversion
Convertible securities allow investors an opportunity to convert them easily without any hassles. This way, an investor can make strategic investment decisions as per prevailing market conditions and effectively earn higher interest returns.
Risks associated with convertible securities
Some of the risks of investing in convertible securities that investors should know of are:
- Drop in EPS: Companies often experience a drop in their earnings per share after introducing convertible securities. The company may therefore find it difficult to avail credit in the future.
- Risk of ownership: Converting securities to common stock results in the company’s shareholders facing the risk of ownership dilution.
Convertible securities can be a good investment option for individuals who have a long investment horizon and can wait until maturity to fetch returns. These are mostly offered by companies with high growth potential, hence their share prices can rise at the end of maturity periods, thereby offering substantial capital appreciation.
Companies may issue convertible securities when they want to raise capital, but at a lower cost since the interest payments in this case are lower as compared to other securities. Growth companies which do not want to use a lot of debt to finance their growth may rely on this financing solution.
Some of the common formats of convertible bonds include vanilla convertible, embedded option, mandatory convertible, exchangeable and currency convertibles.
Mandatory convertible bonds require an investor to mandatorily convert the issued bonds into shares at the time of maturity. These offer regular interest payments until maturity and convert into equity shares on maturity.
One must invest in convertible bonds during periods when bonds are lower in risk than equity stocks. After earning high returns from bonds initially, the investor can become an equity shareholder as the firm achieves stability.
A convertible debenture can be transformed into equity stock after a stated investment period. It is a kind of long-term debt that comes in the form of an unsecured bond, since there is no primary collateral linked to the debt.