Unit
- Convertible security: A hybrid financial instrument that gives the holder the right to convert the security into a predetermined number of shares of the issuer's common stock. This feature combines fixed-income characteristics with equity upside potential.
- Common types: Convertible bonds are the most prevalent, but convertible preferred shares and mandatory convertibles also exist. Each type has distinct features regarding conversion terms, dividend/interest payments, and seniority in the capital structure.
- Convertible bonds: Debt instruments that pay periodic interest and can be converted into equity. They typically have a lower coupon than straight bonds due to the conversion option. The conversion ratio defines how many shares per bond.
- Convertible preferred shares: Equity instruments that pay fixed dividends and can be converted into common stock. They rank above common equity but below debt in liquidation. Preferred convertibles often have no maturity date.
- Mandatory convertibles: Securities that automatically convert into common stock at a specified date or event. They typically offer higher yields than traditional convertibles but require eventual conversion. Examples include PERCS and DECS.
- Contingent convertibles (CoCos): Instruments that convert automatically when a trigger event occurs, such as a breach of capital ratio. These are used by banks to meet regulatory capital requirements and absorb losses.
- Reverse convertibles: Short-term notes that pay high coupons but convert into shares if the underlying stock falls below a certain price. These are more structured products often sold to retail investors.
- Exchangeable bonds: Convertible bonds issued by one company but convertible into shares of a different company (usually a subsidiary or an affiliate). The issuer holds the underlying shares.
- Conversion price and premium: The conversion price is the effective per share cost when converting a bond into equity, derived from the par value divided by the conversion ratio. The conversion premium measures the extra cost of acquiring stock through the convertible rather than directly in the open market. A high premium indicates the bond trades more on its fixed income value, while a low premium suggests the equity feature dominates.
- Parity and conversion value: Parity, or conversion value, represents the current market value of the common shares received upon conversion. This is calculated by multiplying the conversion ratio by the prevailing stock price. Investors compare the convertible bond's market price to its parity to assess the arbitrage opportunity or the premium embedded in the security for its fixed income protection.
- Call protection and forced conversion: Call protection is a contractual period during which the issuer cannot redeem the convertible. After this period, the issuer can call the bonds. If the stock price is sufficiently above the conversion price, bondholders will convert to equity to capture the higher value, allowing the issuer to force conversion and eliminate the debt liability.
- Accrued interest and dirty price: Convertible bonds trade with clean and dirty price conventions. The dirty price includes accrued interest since the last coupon payment. Upon conversion, the holder typically forfeits the right to receive the accrued interest payment. This operational detail is crucial for traders calculating true cost basis and comparing yields across different settlement dates.
Definition
A convertible security is a hybrid financial instrument that grants the holder the right, but not the obligation, to exchange the security for a specified number of common shares of the issuing company (or a designated entity) at predetermined terms. This conversion feature gives the security characteristics of both debt and equity, providing downside protection through fixed income and upside potential through equity participation.
Quick Revision
- Convertible securities combine fixed-income and equity features, offering income and conversion upside.
- Main types include convertible bonds, convertible preferred shares, mandatory convertibles, contingent convertibles, reverse convertibles, and exchangeable bonds.
- Each type has unique characteristics regarding conversion triggers, payout structures, and risk profiles.
- Understanding these differences is essential for structuring and evaluating convertible transactions.