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Convertible Securities Fixed-Income Securities That Are Convertible Into Common Stock

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Convertible Securities Fixed-Income Securities That Are Convertible Into Common Stock Convertible securities Fixed-income securities that are convertible into common stock Convertible securities combine the characteristics and potential benefits of Types of convertible traditional fixed-income securities and common stocks. They are generally securities best-suited for investors who seek to balance their risk/return profile with current • Convertible bonds income and the potential for capital appreciation. • Convertible preferred stock Convertible bonds were key financial building blocks in our Western heritage, • Mandatory convertibles fueling the growth of railroad and telephone companies in the late 1800s. The bonds virtually disappeared when double-digit inflation rates in the 1970s sent bond buyers searching for other ways to preserve their investments. Now, investors who seek both interest income and potential growth in principal appreciate the hybrid characteristics offered by convertible securities. Understanding convertible securities There are principally three types of convertible securities: convertible bonds, convertible preferred stock, and mandatory convertible securities. Convertible bonds are debt instruments that pay interest and have stated maturity dates. Though holders of convertible securities are paid before stockholders in the event of liquidation, securities are often issued as subordinated debt and carry more default risk than the issuer’s senior debt. Convertible preferred stock generally pays a dividend to the holder and does not have a stated maturity. It is usually assigned a symbol and listed on an exchange. Like standard corporate preferred stock, dividends are generally deferrable by the issuer. Convertible preferred securities rank below all debt instruments but above common stock in the issuer’s capital structure. Mandatory convertible securities are unique instruments that do not mature at par like traditional convertible bonds, but instead they automatically convert to common stock on their exchange date, generally three years from issuance. The number of shares of common stock the holder receives at the exchange date is dependent on the price of the common stock but will be no higher, or lower, Investment and Insurance Products: u NOT FDIC Insured u NO Bank Guarantee u MAY Lose Value 1 of 5 than the maximum conversion ratio, or the minimum conversion ratio, both of which are set at issuance. Because of this mandatory conversion feature, the coupon or dividend paid by the issuer on these securities is generally much higher than traditional convertible bonds or preferred stock. How does the conversion feature work? Both convertible bonds and traditional convertible preferred stock give the holder the option—but not the obligation—to convert to common stock at a specified price or “conversion ratio.” For example, a conversion ratio might give the holder the right to convert a $1,000-par convertible bond issued by ABC Corporation into its common stock Convertible calculations at $25 per share. The conversion ratio would then be 40 shares of common stock Conversion ratio (set at per bond. The conversion ratio is set by the prospectus or offering document issuance) is calculated as: when the security is issued.* Par value / conversion price When a bond is converted to common stock, the company that converted the Parity is calculated as: bond to stock has less debt—what was debt becomes equity. As a result, converting debt (bonds) into equity (stock) dilutes the value of all the shares in Conversion ratio x common the company because the percentage of each stockholder’s equity in the stock price company has been reduced. Since most convertible securities are also callable, the company can force investors to convert to common stock by calling the The conversion premium is securities in a practice called “forced conversion.” This is only practical if the calculated as: equity value or “parity” is higher than the convertible security’s call price. (Price – parity) / parity How does the equity market affect convertible securities? When a convertible’s underlying common stock price moves higher, the conversion privilege becomes more valuable. When that happens, the price of the convertible security tends to rise. Likewise, if the common stock price falls, the conversion feature becomes less valuable and the price of the convertible may also decline. However, because of its value as a standalone fixed-income instrument, a convertible bond can help cushion the fall in a declining equity market and offer some downside protection. If the company’s stock declines to a price that makes the convertible feature of the bond worthless (but the company continues to make interest and principal payments), the bond will trade based solely on its value as a fixed-income instrument. Such bonds are often referred to as “busted” convertibles. Why do companies issue convertible securities? Convertible securities are issued by companies that are willing to give up corporate ownership of some outstanding equity shares in order to borrow money. As with other types of fixed-income securities, the higher the credit rating assigned to the underlying security, in general, the lower the interest rate on the bond. The chart on page 4 explains credit ratings. *This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment nor is it indicative of future results. 2 of 5 What are the key factors in valuing a convertible security? • Parity. Also referred to as equity value, parity is simply the value of the bond if it were converted immediately to common stock. An investor would generally not consider converting to common stock unless parity is higher than the current market price of the convertible security. • Conversion premium. The conversion premium is the percentage difference between the current price of the convertible security and its parity value. For example, a convertible security trading at par (100) has a 25% premium if its parity value is 80. • Fixed-income value. A convertible security’s fixed-income value is an estimate of its price without the conversion option. While there is no exact calculation for this value, it is generally estimated by comparing other debt securities from the same, or similarly rated, issuers. • Call or put features. A call option gives the issuer the right to “call” away the convertible security from the holder, generally at a price of par. A put option gives the holder the right to “put” or sell the convertible security back to the issuer, generally at a price of par. Convertible security holders should pay close attention to these features and their provisions as they can be very influential on a convertible security’s value. Who buys convertible securities? Convertible securities may appeal to a wide variety of investors, depending on the characteristics and pricing of the securities. Traditional fixed-income investors may find convertibles with high conversion premiums appealing, while traditional equity investors may invest in convertibles with very low conversion premiums considered to be “deep in the money.” Most convertible security investors, however, look for securities with balanced conversion premiums, approximately 20% – 50%, that allow them to benefit the most from the hybrid features of the security. In other words, they get the most from both the downside protection and income from the security’s fixed income value, while still participating in the upside growth potential of the underlying common stock. 3 of 5 Credit ratings Standard Moody’s & Poor’s Fitch Duff & Phelps Investment-grade ratings Highest possible credit rating – principal and interest payments Aaa AAA AAA AAA considered very secure. High quality – differs from highest rating only in the degree of protection offered to Aa AA AA AA bondholders. Good ability to pay interest and principal – more susceptible to adverse effects due to changing A A A A conditions. Adequate ability to make principal and interest payments – adverse conditions are more likely to Baa BBB BBB BBB affect ability to service debt. Speculative ratings Issuer faces ongoing uncertainties or exposure to adverse business Ba BB BB BB or economic conditions. Greater vulnerability to default, but currently meeting debt- B B B B service requirements. Current identifiable risks of default – in some cases, bonds Caa CCC CCC CCC may already be in default. Bonds in default. C D D D Risk factors Convertible securities typically involve credit, or default, risk; event risk; call, or redemption, risk; and market risk. Credit risk. Credit risk is the risk that an issuer will be unable to make the periodic interest payments or repay the principal. When a bond stops paying interest or the issuer is unable to repay the principal, the bond is considered to be in default. If the corporation declares bankruptcy and defaults on its debt, bondholders, as creditors of the corporation, will have priority over stockholders in the bankruptcy proceedings. To assess a bond’s credit risk, investors can look to the credit ratings assigned by independent credit-rating agencies, which include Moody’s Investors Service, Standard & Poor’s, Fitch Investors Service, Inc., and Duff & Phelps Credit Rating Company. Normally, the lower the rating on a bond, the higher the potential yield and the higher risk of default. Issuers must compensate investors for assuming additional credit risk by offering higher interest rates on corporate bonds. Please make sure to check the credit rating of a corporate bond before you make a purchase. Investors should of course note that an investment grade rating does not insure the bond against default and does not guarantee the return of principal. 4 of 5 Event risk. Event risk in convertible securities is normally associated with Glossary events affecting the corporate issuer. Leveraged buyouts, mergers, takeovers, or recapitalizations can often increase a corporation’s debt load. These factors can The period of Call protection. have a serious impact on the credit ratings assigned to a corporate issuer, as well time during which a as the value of the bond.
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