What Is a Mandatory Convertible?
A mandatory convertible is a type of convertible bond that has a required conversion or redemption feature, rather than the convertible feature being an option. For these bonds, either on or before a contractual conversion date, the holder must convert the mandatory convertible into the underlying common stock.
Key Takeaways
- A mandatory convertible is a bond issued by a company which must be converted into shares to common stock on or before a specific date.
- Traditional convertible bonds allow bondholders the option of converting, while in a mandatory convertible this is required.
- Because of this, holders of mandatory convertibles enjoy a higher yield than on regular convertible bonds.
Mandatory Convertibles Explained
A mandatory convertible is a security that automatically converts to common equity on or before a predetermined date. This hybrid security guarantees a certain return up to the conversion date, after which there is no guaranteed return but the possibility of a much higher return. This differs from the standard convertible bond in which the holder has the option of exercising his or right to convert the fixed income security into shares at the issuing company. A normal convertible bondholder might choose to convert or to leave the bonds in his or her portfolio depending on the market conditions of the equity and bond market, providing a downside protection for the investor in the event that the share price of the company does not perform as expected.
Since mandatory convertibles strip the bondholder of any conversion options, investors are provided with higher yields than ordinary convertibles to compensate holders for the mandatory conversion structure. The issue price of the mandatory convertible at the time of issuance equals the price of the common stock. The trust indenture lists the conversion price, which is the price at which the debt securities are convertible into common stock at a premium to the issue price upon maturity. In actuality, two conversion prices are stated with a mandatory convertible – the first conversion price limits the price in which the investor would receive the equivalent of its par value back in shares, the second would delimit the price in which the investor will earn more than par. If the stock price is below the first conversion price the investor would suffer a capital loss compared to his or her original principal investment. Instead of the conversion price, the conversion ratio might be stipulated instead; the conversion ratio is the number of shares that an investor can expect to have each par value bond converted into. This ratio changes depending on the issuing company’s stock price.
The application of mandatory convertible bonds is similar to that of mandatory convertible preferred shares, in which case, preferred shareholders must convert their shares to common stock at a specified date.
Other Considerations
There are two common ways a company can raise capital – equity issuance or debt issuance. When a company issues equity, its cost of equity is dividends to shareholders. Not all companies pay dividends, however, in which case, shareholders expect a return on investment determined by capital appreciation in the share price. The cost of debt for issuing debt or bonds is the periodic interest payments that are to be made to bondholders. A company’s decision on how to raise money to finance its capital projects depends on the accessibility or cost of each security issuance.
Sometimes, companies stray from pure debt or pure equity issues to gain flexibility in adjusting its capital structure or reducing its cost of capital. A company may choose to issue debt if general market conditions are not favorable to an equity issue or if a traditional equity issuance would otherwise place severe market pressure on the price of the existing shares in the market. If this is the case, the debt issued may have a mandatory convertible feature which will allow the debt to be converted into equity at a more favorable time. A bond with a mandatory convertible feature will be highlighted on the trust indenture at the time of issuance.
FAQs
A mandatory convertible is a type of convertible bond that has a required conversion or redemption feature, rather than the convertible feature being an option. For these bonds, either on or before a contractual conversion date, the holder must convert the mandatory convertible into the underlying common stock.
How does the convertible work? ›
A motor that turns a gear on each side of the car powers the mechanism that raises and lowers the roof. The gear engages a bracket that has gear teeth cut into it (much like the mechanism used in power windows). This bracket is connected to the main structure of the roof.
What are convertible bonds and how do they work? ›
A convertible bond is a fixed-income corporate debt security that yields interest payments but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond's life and is usually at the discretion of the bondholder.
How do you calculate the fair value of a convertible debt? ›
To accomplish convertible bond valuations, investors may rely on the following formula: Value of convertible bond = independent value of straight bond + independent value of conversion option.
What happens if you can't pay back convertible note? ›
In such a case, the convertible noteholders have several options: Force a repayment. Technically speaking, the noteholders could demand repayment of the note. Because the company is unlikely to be able to do so, this could force the company into bankruptcy.
Is convertible debt good or bad? ›
Provides safety and security of debt: Convertible debt provides investors with the safety and security of debt, which is typically less risky than equity investments. This is because the investor's initial investment is secured by the company's assets, and they are guaranteed a fixed rate of return.
What are the disadvantages of a convertible? ›
Even with your roof closed, convertibles (especially soft tops) often don't offer the noise insulation that a fixed roof might. Additionally, depending on the amount of time you spend driving with the top-down, your car seats and other cabin components may experience additional wear and tear.
What is the benefit of a convertible? ›
Driving a convertible with the top down offers better visibility, making it easier to maneuver and park. With no fixed roof or door frames obstructing your view, you'll be able to see your surroundings more clearly (with fewer blindspots).
Is convertible debt the same as a bank loan? ›
At its most basic, convertible debt is a loan — an investor gives your startup money to build the business. But unlike bank loans and credit cards, you don't pay back the loan with more money.
What are the risks of convertible bonds? ›
Liquidity Risk: Convertible can be less liquid than corporate bonds, especially in times of market stress. Equity Risk: The equity price may never reach the conversion price, thereby negating the value of the option to convert.
The owner of a convertible bond owns, in effect, both a bond and a call option.
Who can convert a convertible bond? ›
A convertible bond is a fixed-income security that can be converted from a bond into shares of an issuing company. At the bondholder's discretion they may convert the single bond into a set number of company shares at a set conversion price.
Why is it hard to value convertible bonds? ›
The valuation of a convertible bond is made more difficult due to the underlying characteristics. When pricing, one must consider the underlying bond and equity details. For example, the equity price, maturity, coupon, volatility and spread must all be considered.
What is the formula for convertible price? ›
The conversion price of the convertible security is the price of the bond divided by the conversion ratio. If the bonds par value is $1,000, the conversion price is calculated by dividing $1,000 by 5, or $200. If the conversion ratio is 10, the conversion price drops to $100.
What happens when convertible debt is converted? ›
Typically, the result is that the amount will convert to shares. If the convertible notes convert into shares, the company will need to determine how many shares to issue to the noteholder. To do so, the company will usually divide the loan amount, plus any accrued interest, by a certain share price.
How does a convertible promissory note work? ›
A convertible promissory note is a legal document that is a type of debt instrument that can be converted into equity for a business. A convertible promissory note will typically have a fixed interest rate and a maturity date, but the holder has the option to convert it into shares at any time before its due date.
How does a convertible security work? ›
A "convertible security" is a security—usually a bond or a preferred stock—that can be converted into a different security—typically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert.
How does a convertible loan work? ›
Convertible loans are loans through which startups receive debt capital – but with a particular feature. A convertible loan grants lenders the right to convert debt into equity at a later date, typically during the next financing round.
How does a convertible term policy work? ›
Convertible term allows you to exchange your term temporary coverage for a permanent policy at a later date. While term premiums are less initially expensive, you need to pay more each time the term expires for a renewal. The coverage also does not last your entire life.
