Convertible securities offer investors the growth potential of common stocks and the income of bonds.
Issued by companies looking to raise capital, these hybrid investments are generally structured as some form of debt (bonds, debentures) or preferred shares with an embedded option that allows conversion into common shares under predetermined conditions.
Essential Links:
- The Financial Post’s full list of TSX Convertible Debentures with current price, yield, maturity date and conversion information
- More description of key terms and taxation from H.C. Levant
- Case study in distressed debentures: Holloway Lodging wipes out existing shareholders by converting out-of-the-money debentures to shares.
The debt features of convertibles: Interest payments and claim to principal
In this respect, convertibles are similar to bonds and characteristically are typically expected to provide better protection against erosion of value in declining markets than the underlying common stock.
Embedded conversion component allows investors to participate in the stock’s price appreciation
If a company’s common stock rises, the convertible security should increase in value because of the conversion option. Historically, they have tended to perform well during periods of above-average market volatility.
WHY COMPANIES ISSUE CONVERTIBLES
- Lower interest payments relative to straight debt
- Less potential share dilution compared to equity issuance
- Equity issued at a premium to the current stock price
- Ability to reach a broader range of investors
Within a company’s capital structure, convertibles can be ranked at various levels of seniority ranging from the most junior preferred stock to senior secured debt. Most convertibles are issued as senior unsecured debt, which ranks higher than stocks with respect to income distribution or liquidation.
ANATOMY OF A CONVERTIBLE
Conversion ratio: The number of common shares due upon conversion to the underlying stock.
- The conversion price is calculated by dividing the price of the convertible at issue by the conversion ratio.
- This determines the price of the underlying common stock that is required for the conversion value of the convertible to be greater than its par value.
- The conversion price is set upon issuance at a premium of anywhere from 15% to 50% relative to the price of the underlying common stock, with 20% to 30% the most typical range.
Parity refers to the value of the convertible upon conversion. It is calculated by multiplying the conversion ratio by the current stock price.
Conversion premium is the value by which the price of the convertible exceeds its parity and is calculated as a percentage of parity.
Delta measures the sensitivity of the convertible price to changes in the price of the underlying common stock.
BUSTED, BALANCED OR EQUITY-LIKE?
Based on the conversion premium, convertibles can be broken down into three distinct categories: busted, equity-like and balanced.
Bond-like or “busted” convertibles are “out of the money”
Because the conversion price is substantially greater than the equity price, the conversion option is unlikely to be exercised. Busted convertibles have less sensitivity to the movement of the underlying common stock. Similar to bonds, they provide income and protection during market declines but offer less potential for upside participation.
Equity-like “in the money” convertibles
Their conversion price is equal to or less than the equity price, which results in higher sensitivity to the stock price. Because equity-like convertibles closely track the underlying stock, they can offer greater upside potential. However, this also means they are nearly as volatile as the underlying stock.
Balanced convertibles tread the middle ground with a moderate level of conversion premium and equity sensitivity. One of their typical primary advantages is an asymmetric risk/return profile, which can result in greater participation in the potential upside return of the underlying stock and lower participation in the stock’s potential downside return.
XYZ Corp. issues a three-year convertible bond with a $1,000 par value and a semiannual coupon of 1.5%. The conversion ratio is 10.5, making the effective conversion price $95.24 per share ($1,000 ÷ 10.5 = $95.24). The investor receives $7.5 in income twice a year ($1,000 x 1.5% ÷ 2 = $7.5), for total income of $15 each year. Today, the common share price is $75 and the convertible price is $1,000. The common stock pays no dividend. What happens to the convertible as the price of the underlying stock increases (scenario A) or decreases (scenario B)?
Scenario A. With a $75 stock price and a $1,000 convertible price, the conversion premium is 27% ([$1,000 ÷ $75 x 10.5] – 1 = 27%). Suppose the underlying equity increases by 20% to $90 over a period of 12 months. This will generally lead to an increase in the convertible price, since conversion becomes more attractive and likely with the common stock price appreciation. Say the convertible price increases to $1,125. In this case, the convertible price return is +12.5% ([$1,125 ÷ $1,000] – 1 = 12.5%). Including the coupon payments of $15 (two semiannual coupon payments of $7.5) leads to a total convertible return of 14%. Thus, the convertible delivered 70% of the of the stock price appreciation (14% ÷ 20% = 70%). Generally, as the stock price approaches the conversion price, the conversion premium declines and equity sensitivity (delta) rises.
Scenario B. Suppose instead that the stock price falls 20% to $60. The convertible price will generally decrease as well, since the underlying common stock price depreciation makes the conversion option less valuable. Let’s say the convertible price declines 11.5% to $885. The convertible’s total return is -10% ([$885 + $15 – $1,000] ÷ 1,000 = -10%), compared to the stock’s total return of -20%. In this case, the downward movement in the convertible price is half the change in the stock price, highlighting the convertible’s defensive profile relative to the underlying common stock.
BUYER BEWARE
As a group, convertibles have historically presented an attractive risk/reward profile, but within the group there is considerable variation in the level of risk, sensitivity to movements in the underlying stock, and upside participation potential.
Convertible securities are diversified across credit ratings, sectors, market capitalization and investment characteristics. But TSX-listed convertible debentures are usually issued by small cap companies with no access to lower-cost debt financing. In terms of credit ratings, the universe is roughly split equally among investment grade, intermediate/lower grade and non-rated issues. The universe is also well diversified by sector.
While default risk is an important factor when evaluating securities, many other elements must be considered before making an investment, such as business fundamentals, asset and cash flow coverage of debt and fixed costs, and the likelihood of improvement in the underlying credit profile.
OTHER RISKS
- Bond prices generally move in the opposite direction of interest rates.
- High yields reflect the higher credit risk and, in some cases, the lower market prices for these instruments.
- A convertible security is not as sensitive to interest rate changes as a similar non-convertible debt security, and generally has less potential for gain or loss than the underlying stock.
