Convertible securities are generally issued by companies to raise funds for their functioning, who usually reserve the right to determine the time of conversion of these securities. Furthermore, these securities also help in enhancing the outreach of a company with a direct positive impact on their market reputation. It is important to note that the availability of shares impacts the credibility of a company as well.
Types of Convertible Securities
Though some of the features of convertible securities are similar, it is important to note the specific characteristics of its different types. Typically acting as both debt and equity, the basic features are discussed below in detail.
These are fixed income securities which are converted to equity shares of a company which issued this bond at the time of maturity. One of the options among convertible debentures, the basic features of these bonds is discussed below.
- Price of conversion: As a feature, it is important to note the price of conversion for such bonds. The total price at which an ordinary share is issued is known as the conversion price and it is determined on the basis of factors like existing value of the book, market price, etc. Typically this conversion price is much higher than the price of a convertible bond, allowing the investor to make a profit when these convertible debt securities mature.
- Coupon payment: Convertible bonds are essentially debt securities which are more secure than all other types of equity securities. They have coupon payment which means that interest rate and credit quality of their issuer decide the value of these bonds and in turn the shares.
- Subject to conversion ratio: The number of equity shares an owner receives in exchange for his/her convertible bonds is known as the conversion ratio. This ratio is determined by the issuer of the bonds when an owner buys them.
This ratio does not impact the value of the convertible securities. However, it decides the total value of the equity shares that an owner will get when his/her investment matures.
- Convertible preferred stocks
Preferred stocks are the common shares which get preference over equity shareholders. In the case of convertible preferred stocks, a dividend is paid at a fixed rate or percentage at the time of maturity. These types of convertible securities can also be converted into common equity shares of a company when they mature.
- Guaranteed dividend payment: These stocks have guaranteed dividend payment since these are ranked above common shares. Consequently, in case the company defaults, convertible preferred stocks will get the highest preference of repayment.
- Ease in conversion: Representing ownership of the company, convertible preferred stocks are easily converted to equity shares when they reach their time of maturity.
- Multiple types: While this is itself a type of convertible security, there are quite a few types of preferred stocks. These can be cumulative preferred stocks, callable preferred stocks, participating preferred stocks, and convertible. Among them, convertible stocks are typically issued to angel investors and its likes.
Advantages of convertible securities
The common advantages of securities which are convertible are explained underneath.
- Ease of conversion: The different types of bonds and debentures which are convertible, allow their owners the chance to convert them fast and without any hassle. This allows them to better adapt to market conditions and in turn effectively earn more in interest payment.
Any owner can easily convert their convertible securities to a different form if they consider a specific financial instrument to be risky in the prevalent market situation.
- Tax Benefits: Compulsorily convertible debentures and some specific types of securities which are convertible are eligible for tax benefits. The interests earned on these securities are eligible for deduction from the total taxable income of an investor. However, investors must also keep in mind that these securities might not be eligible for tax benefits after they are converted.
Disadvantages of Convertible Securities
The few disadvantages which also accompany the advantages of convertible securities are listed below.
- Risk of dilution: EPS or Earning Per Share rate of the stocks of a company go down when it introduces convertible securities. This can lead to further difficulties for the company in availing any line of credit from a financial institution for themselves in the future.
- Risk of losing ownership: When a company converts its securities to common equity, the majority of shareholders always run the risk of losing ownership. Essentially, dilution of the share can lead to the ownership being diluted across multiple shareholders.
Who Should Consider Investing In Convertible Securities?
Understanding the features of convertible securities also help in deciding the best type of investors for these securities. Typically, these are a good investment option for individuals who can wait for the maturity period to conclude. These are attractive to investors especially since these are offered by companies who have high growth potential but are low on capital. Consequently, when the maturity period ends these companies can be expected to have high priced shares, making the return on the investment substantial.
However, it is also important for investors considering investing in convertible securities to have a good knowledge of the market conditions and its trends. This allows them to gauge the associated risks and accordingly convert their securities as per their investment planning.
- Why do companies issue their convertible securities?
Convertible securities and debts offer discounts to companies, unlike corporate debts, thereby prompting them to issue these securities.
The value of a bond if the equity option becomes worthless is known as the Bond floor.
Convertible securities which are offered to new investors so that they can become a shareholder are known as Public Issues. It can be done by both unlisted companies and listed companies.