What are Convertible Securities?
Convertible securities are financial instruments that can change from one form to another. In other words, they are securities that can be converted into equity shares at the time of maturity. The holder has the option to convert it or not at the time of maturity. Right at the time of issue, the issuer specifies the qualifying terms, such as price and time of conversion.
Convertible security pays a fixed interest to the holder, which is usually lower than a non-convertible security of a similar kind. This is mainly because investors are willing to accept a lower interest against the gains they can earn when the security converts into stock.
The company sets the conversion price higher than the current stock price. If the price is closer to the market price at the time of conversion, then there are high chances of conversion. However, if the current share price is way below the conversion price, then the prospects of conversion are very few.
Convertible security has two important features, and they are:
- Conversion ratio: The number of shares that will be allotted against the bond is the conversion ratio, and the company predetermines it at the time of issue.
- Fixed coupon: Convertible securities pay a fixed coupon or dividend to the holders against their investment.
Types of Convertible Securities
The most common type of convertible securities is bonds and preference shares.
Convertible bonds are debt securities that pay interest to the holders. They are hybrid securities that have features of both equity and debt. These bonds give the investors an option to convert the bond at the time of maturity. If the investor converts the bonds, then they will get equity shares against the bond. The number of equity shares is predetermined. In case the bonds are not converted at the time of maturity, then the face value of the bond is repaid to the investor.
Convertible bonds pay an interest that is lower than regular bonds. This is mainly because the bondholder will benefit from a high share price at the time of conversion. Companies prefer issuing convertible bonds when the interest payment is lower, giving the company some time before their shareholding dilutes.
Convertible preference shares
Preference shares are securities similar to equity shares, but they have the first preference on the dividend and assets of the company during dilution. Though they do not have voting rights, they are eligible for a regular dividend. Upon maturity of the preference shares, the shareholders have the option to convert them into equity. Once the company converts preference shares into equity shares, the shareholders get voting rights and get dividends only when the company declares it.
Advantages and Disadvantages of Convertible Securities
Advantages of convertible securities
- Ease of conversion: These securities have the feature to easily convert from one form to another. This is because the conversion can take place without a hassle. Investors can opt for conversion if they feel the prevailing market conditions are risky for a specific instrument. Hence, they can easily adapt to market conditions and make good investment returns.
- Tax benefits: Some of these securities are eligible for tax benefits under the Income Tax Act 1961. The interest earned on these securities is usually tax-free. However, it is important to note that the same tax benefits might not apply to the new financial instrument after conversion.
Disadvantages of convertible securities
- Difficult to get credit: Once a company issues convertible security, upon conversion, the earnings per share falls, making it difficult for the company to obtain credit for its operations.
- Dilution of ownership: After the conversion of the securities, the company’s ownership dilutes. This, in turn, reduces their share and voting rights in the company, which interferes with the company’s management.
Who Can Invest in Convertible Securities?
Convertible securities pay a fixed interest or dividend. Hence, they suit investors who want to earn a regular income from their investments. Moreover, they also suit investors with long-term goals and can wait until the date of maturity to earn good returns. Companies with high growth potential and low on cash issue these securities, and once the maturity period ends, investors can gain from capital appreciation.
However, investors of convertible securities should have good knowledge about market trends and conditions. This is because it is important to gauge the market conditions during conversion, and only then can they take an investing decision.
Frequently Asked Questions
Companies issue convertible securities as they have a lower coupon or dividend payments than the non-convertible option. This gives the company an advantage as their fixed cash obligations are low and also gives them time before the company’s shares are diluted.
Though convertible securities pay low coupon or dividend payments, investors invest in them for several reasons. First, they pay a fixed interest, and second, they can gain through capital appreciation upon conversion. This motivates them to invest in convertible securities.
Convertible securities are considered hybrid as they possess the characteristics of both equity and debt. Investors get regular interest or dividend payments similar to debt securities. They also earn through capital appreciation upon conversion, which is higher than the income they would’ve earned through common equity.