Convertible Securities

Convertible Securities are securities or investment (preferred stocks or convertible bonds) which could be very easily converted into a different form like shares of an entity’s common stocks and these are generally issued by entities for the purpose of raising money and in most of the cases, the entity has all the rights to determine when actually the conversion takes place.

The convertible securities are preferred over non convertible securities for investments, given the lesser payout involved and more fruitful returns expected. Investors aiming to have a diversified portfolio are recommended to convert their security forms as and when they get an opportunity.

• Convertible securities are financial instruments, such as bonds, preferred stocks, or notes, that can be converted into additional security, usually common stock, at the holder's option.
• The critical feature of convertible securities is the option it provides to the holder to convert their securities into a predetermined number of shares of the underlying issuer's common stock.
• Convertible securities combine features of both debt and equity instruments.
• Convertible securities provide advantages to both issuers and investors. For issuers, they offer a cost-effective method to raise capital, often with lower interest rates than traditional debt. For investors, they provide an opportunity to gain exposure to the potential growth of the issuer's stock while still enjoying fixed-income characteristics.

Convertible securities, as the name implies, allow investors to covert one form of their security into another whenever they get a chance to do so. Such securities can either be a bond or preferred shares, which can further be converted to common shares of a company stock.  These securities behave like bonds when there is a drop in the prices of the underlying equity, while they act like a stock when the equity value rises. This adjustment in behavior makes them a stable financial instrument for most people looking for a safe place to invest in.

These are financial instruments that can be converted into different securities that have a different nature or working or different terms for redemption. Basically, it takes the form of a different type of security after the term of conversion is ended. The term and the obligation of both the parties, i.e., shareholders and the company, are changed after the security is converted into a different financial instrument.

When one owns a convertible asset, they acquire the right to convert it into a security form, other than the form they have owned it in. However, the investors here are not obligated to convert securities. It is up to them whether they would like to go for the conversion opportunity. The number of securities that can be converted along with other clauses are detailed in the documents concerning this provision to convert securities.

These securities give investors an opportunity to invest in one type of security and then switch to other form of it later on. However, this conversion is not allowed as per the feasibility of the investors. Instead, there are factors that help them identify the right opportunity for conversion. There are specific qualifying terms and price at which the conversion can take place. This conversion of securities comes with a fixed payment periodically. The payment is a coupon payment for bonds and preferred dividend for preferred shares.

Convertible securities are instruments that belong to the hybrid asset class, being the one exhibiting the behavior or both bonds and stocks. Similarly, they have many other characteristics that one must be aware of to understand how the returns are calculated and what determinants play important role in the working of this conversion. Let us have a look at some such features below:

• These securities have a conversion ratio that puts a limitation on the number of shares that will be allowed to be converted at the time of maturity. It is a predetermined ratio and investors get a specific number to know how many securities they could convert at one point in time.
• The returns on the convertible securities are steady, be it for bonds or for preferred shares. While the investors receive the return in the form of coupon payment for bonds, they get it as fixed dividends for preferred shares or stocks.

While convertible securities allow investors to convert one form of security to any other form of security, the major ones that are opted for to be converted to include the following:

#1 - Convertible Bonds

Convertible bonds are those that convert into a fixed number of shares of the issuing company, usually at the time of their maturity. Thus, such bonds have features of equity as well as debt.

#2 - Convertible Preferred Stocks

Preferred stocks are those kinds of common shares that get preference over equity shareholders, and convertible preference shares are those who are paid a dividend at a fixed price or a percentage and which get preference over the common equity shares at the time of liquidation. They are convertible in nature in the sense that preference shares can be converted into common equity shares as per the terms and agreement and the nature of the instrument, which is issued by the company.

Let’s see some simple to advanced instances to understand convertible securities meaning and check how they work:

Example 1

Company XYZ is engaged in the service industry and has a $1,000 par value bond, which is convertible into common stock. It has a coupon rate of 5%, which is paid annually. The bond prospectus specifies a conversion ratio of 30. How many shares will a shareholder get if he has invested $1,000 in the company?

Solution:

The conversion ratio is given in the problem, which is 30, which means that the investor will get 30% worth of shares in proportion to his shareholding of the bonds.

So the problem can be solved with the following steps:

Worth of common shares that the investor will get = $1,000 / 30 = $ 33.34

Example 2

Dilip Buildcon is engaged in the construction industry and has a growing presence in the markets of the middle east and northern Africa. The company has a $3,000 par value bond, which is convertible into common stock. It has a coupon rate of 5%, which is paid annually. The bond prospectus specifies a conversion ratio of 50. How many shares will a shareholder get if he has invested $3,000 in the company?

Solution:

The conversion ratio is given in the problem, which is 30, which means that the investor will get 50% worth of shares in proportion to his shareholding of the bonds.

So the problem can be solved with the following steps:

Worth of common shares that the investor will get = $3,000 / 50 = $ 1,500

There are pros and cons to the use of convertible security for financing. I; investors should consider what the issue means from a corporate standpoint before buying in. Also, they should consider the financial situation of the company before going for a subscription of a convertible security. Investors should thoroughly review the bond prospectus before investing.

Benefits

• It gives an advantage to the investor, which converts the risk of security from one instrument into another. For example, if the investor has a bond and it is convertible into equity security, then the investor is into a better position to earn a return on its investments.
• It also gives flexible options for lower interest payments in case it is convertible into common shares and has lesser maturity tenure.
• Tax advantages are also there in the case of convertible securities.

Limitations

• One disadvantage is that financing with convertible securities runs the risk of diluting not only the EPS of the company's common stock but also the control of the company. Hence the investment banker who is running the issue faces a hard time to raise money from the banks for the company.
• Conversion of securities into common equity also has the risk of voting rights as it leads to a dilution of voting rights among a larger group of shareholders, which in turn results in dis-ownership of the founders of the company.

Convertible securities and warrants are two components of the capital structure of any company. Though their objective is to offer good returns to investors, they differ in the way they offer the opportunity to profit to investors. Let us have a look at the differences between the two:

• Convertible securities offer rights to investors to convert their form of assets into other forms, while warrants exhibit paid conversion feature. This means that investors can get the additional rights of converting the form of the security only after paying a price for it.
• Convertible assets are one-time investment. On the contrary, warrants can be invested in multiple times to make more profits.
• While convertible securities are preferred when investors want to feasibly survive even the worst market scenarios, warrants are financial instruments that are opted for maximum rewards.
• The former is considered a long-term investment as it does not have fixed term or expiration date to follow. The latter, on the other hand, has an expiration date and hence, it is considered a short-term investment option.

This has been a guide to what are Convertible Securities. We explain its examples, types, features, advantages & disadvantages, and differences with warrants. You can learn more about financing from the following articles –

• Par Value of Share Definition
• Contingent Shares
• Stock Dilution
• Floating Stock