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Convertible Securities – risky or risk averse?
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Convertible securities are the one which can be changed into another form of security. These usually pay a fixed amount of payment at regular intervals and specify the price at which it can be converted into common stock. These securities generally have a lower payout as compared to other securities. But the investors accept lower payout due to the conversion feature available.

Convertible bonds

They can be exchanged at the will of the holder for a specified number of common stocks at a conversion price. They have the same features as that of bonds, which are:

a) They pay a fixed percentage of interest.
b) They posses a redemption value at the time of maturity.
c) They constitute part of company’s debt rather than equity.
d) They are issued with call protection for a specific time period.

Convertible preferred stock

This can be exchanged for a specified number of common stock at a conversion price at the will of the holder. These securities pay dividends  and are given preference in rights and payments to the ordinary shareholders. They are also issued with call protection.

Who issues convertible securities?

These securities usually offer low payout which makes it beneficial for a company to issue these. Such securities offer a chance to companies to issue common stock at a premium price than the current market price. Companies issue convertible securities to broaden their investor base and possess a flexible capital structure. These securities also provide an option to the investors who are willing to change the kind of security they are investing in for a particular company.

For example :

Consider a company whose bond has a par value of Rs. 1000 which is convertible into the company’s common stocks. The coupon rate is 7% payable annually. The bond’s prospectus specifies a conversion ratio of 20. So the investor will purchase 20 shares of the company @ of Rs. 50 each (Rs.1000/20). Each year the bond holder will receive Rs. 70 as coupon interest.  After 2 years the company provides to convert the bonds into shares and the market price of shares is Rs. 75 per share. In this case the investor is benefittted since the market value of the shares is higher than what was expected. The investor’s investment is worth Rs. 1500 (Rs.75X20) now.

Advantages of issuing convertible securities

To the issuer

  1. The convertible securities when issued contain a low payout therefore the issuer has a reduced cash interest payment. This ensures lower fixed rate borrowing costs. Thus fixed costs of the issuer are reduced especially in case of convertible bonds where interest payment is compulsory even in case of losses to the issuer.
  2. When the holder exercises its option of converting the securities into common stocks then debt of the company vanishes without making much efforts. In case of higher debt component before conversion, after  conversion, the issuer gets an opportunity to maintain desired debt levels according to the industry standards.
  3. The securities are converted only after the call protection period, till then they help in increasing total level of debt gearing in the capital structure of the issuer company.
  4. Until conversion, the issuer company has more of operating income for common stockholders because debt holders are paid a limited amount.     

To the investor

  1. Convertible securities are a form of asset protection for the investor. The value of convertible bonds will fall only to the level of bond floor and not beyond that. This provides security to the investor from steep   fall in market prices of securities. 
  2. Such securities are less volatile than ordinary shares in the securities market.

Risks of issuing convertible securities

  1. Companies with weak financial position issue convertible bonds to sell their debt securities. The investors should be careful since the issue will never be converted because the market price of its equity shares will never rise above the market price of the bonds issued.
  2. Bonds with weak credit ratings but potential for growth are able to sell their debt securities at normal costs not because of the quality of bond but because of conversion feature avaliable.
  3. The current owners may lose control over the company. After conversion if large part of issue is purchased by one entity such as an investment banker then the current owners may dilute their voting share and other rights.
  4. Higher use of convertible debts or fixed income securities may lower down the benefits available to ordinary shareholders when sales and earnings decline. The dependence on debt may increase further leading to insolvency and default in payments.

 

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