Mandatory Convertible
Contents
Demystifying Mandatory Convertibles: A Comprehensive Guide
Key Takeaways
- Mandatory convertibles are bonds that must be converted into common stock by a specific date.
- Unlike traditional convertible bonds with optional conversion, mandatory convertibles require conversion.
- Investors in mandatory convertibles enjoy higher yields compared to regular convertible bonds due to the mandatory conversion structure.
Understanding Mandatory Convertibles
Mandatory convertibles represent a unique type of security that automatically converts to common equity on or before a predetermined date. This conversion feature eliminates the bondholder's option to convert, providing a higher yield to compensate for the mandatory conversion. Unlike traditional convertible bonds, where bondholders can choose to convert based on market conditions, mandatory convertibles offer no such flexibility.
Mechanics of Mandatory Convertibles
The issuance price of mandatory convertibles equals the price of the common stock, with the conversion price specified in the trust indenture. This price determines the conversion rate, dictating the number of shares the investor will receive per bond upon conversion. Typically, two conversion prices are specified: one to ensure the investor receives the par value back in shares and another for potential capital appreciation. If the stock price falls below the first conversion price, the investor may face a capital loss.
Comparing Mandatory Convertibles to Other Instruments
Mandatory convertibles share similarities with mandatory convertible preferred shares, where preferred shareholders are obligated to convert their shares into common stock. Companies may opt for mandatory convertible bonds to raise capital when market conditions are unfavorable for equity issuance. This strategy offers flexibility in adjusting the capital structure and reducing the cost of capital.
Considerations in Capital Raising
Companies weigh the costs and benefits of equity and debt issuance when raising capital. While equity issuance involves dividends to shareholders, debt issuance incurs periodic interest payments to bondholders. The decision on the method of capital raising depends on factors such as market conditions and cost considerations. Mandatory convertibles provide an alternative avenue for companies to access capital, offering a balance between debt and equity financing.