What Are Hung Convertibles?
Hung convertibles refer to convertible securities in which the market value of the underlying security falls significantly below the conversion price. This situation diminishes the likelihood of these securities being converted into common stock. As unconverted securities are typically redeemed at face value, issuers aim to avoid the scenario where their convertibles remain hung.
Convertible securities, encompassing bonds, notes, or preferred stock, possess the unique feature of being convertible into the common shares of the issuing company at a predetermined price and date in the future. Many companies with a lower credit rating opt for issuing convertible securities as a cost-effective means of raising capital.
Understanding Hung Convertibles
When convertible securities are unlikely to convert into stock, they are labeled “hung convertibles.” This situation is most prevalent when the conversion cost exceeds the underlying stock’s price. Due to their limited likelihood of conversion, hung convertibles, also known as busted convertibles, exhibit trading patterns more akin to those of debt instruments than quasi-equity securities. The term “hung convertibles” can also encompass scenarios where conversion is improbable.
- If the issuer cannot compel conversion until the underlying common stock attains a pre-defined price level,
- When the call date is distant.
Hung convertibles typically trade more in line with other debt instruments, reflecting the diminished probability of conversion. However, when the underlying security price reaches a level justifying conversion, they tend to exhibit behavior more aligned with equities.
Example of a Stalled Convertible
Stalled convertibles can manifest as bonds backed by collateral or debentures relying on the issuer’s promise to fulfill obligations. Consider a convertible debenture with a $1,000 face value that is convertible into 100 shares at a conversion price of $10. If the underlying stock price is $4, categorize this debenture as a stalled convertible, especially if it matures relatively soon.
In such a scenario, we would value the debenture as a debt instrument, considering factors like the coupon rate, maturity, prevailing market interest rates, yields, and the issuer’s credit rating.
Addressing the issue of a stalled convertible necessitates the improvement of a company’s fundamentals, such as revenue growth, operating margins, or return on invested capital. This enhancement aims to sufficiently boost the common stock’s value to reach the conversion price.
Convertible securities encompass many advantages found in both bonds and equities.
Benefits and Limitations of Hung Convertibles
Some investors often see Hung convertibles as an optimal blend of benefits, combining bonds’ income-generating and stable price attributes with the added advantage of a conversion feature. This feature opens the door to acquiring common stock shares, historically known for their superior capital appreciation and lower sensitivity to interest rate fluctuations compared to bonds.
In essence, investors enjoy a dual advantage: they receive coupon payments, serving as compensation while waiting for maturity or conversion into common equity. For those inclined towards equity investments, convertibles offer a unique opportunity for partial participation in upward market movements and increased downside protection during market turbulence, surpassing the outright ownership of common stock.
However, it’s crucial to acknowledge the downsides associated with hanging convertibles. The conversion feature leads to lower coupon rates than bonds with similar maturity and credit quality. According to Calamos Investments, a convertibles investment manager, this discrepancy can range from 300 to 400 basis points—a significant margin, especially in today’s low-interest-rate environment. Additionally, investors may hold a lower-yielding bond if the issuer’s stock performs poorly.
Special Considerations
Evaluating convertible securities involves an intricate process as it necessitates the simultaneous analysis of elements affecting bonds, such as interest rates, and factors influencing stocks, such as earnings growth. The valuation of a convertible bond is particularly intricate when it hovers near its investment value, comparable to that of a non-convertible bond, as its price dynamics become more responsive to fluctuations in interest rates. Conversely, when a convertible bond is closer to its conversion value, its price is less influenced by interest rates. Although there are nuances, we generally observe that changes in the underlying fundamentals of the issuing company have the most significant impact on the price of a convertible security.
Conclusion
- Under certain circumstances, holders of convertible securities may be able to redeem their investments for either cash or shares in the issuing business.
- Investors commonly refer to this type of convertible security as a “hung convertible” or a “busted convertible” due to the uncertainty surrounding converting the underlying security into common stock. Because of this low likelihood of conversion, it trades more like a debt instrument.
- Due to the monetary nature of these responsibilities, most corporations would rather not deal with hanging convertibles.
- To fix a hanging convertible, a business should work on its core competencies to increase the value of its common stock until it reaches the conversion price.
