Sometimes you can receive stock in another way: conversion. As discussed earlier, some bonds or preferred shares can be converted into common shares.
- These fixed-income instruments (that is, securities that pay steady interest or dividends) with a convertibility feature are usually issued with rates below the prevailing yields for non-convertible bonds.
- At the time the convertible bond or preferred stock is issued the conversion price is fixed at a price higher than the market price of the underlying common stock..
- Converting the bond or preferred stock will only make sense when the price of the underlying stock equals or exceeds the current market value of the convertible security.
An investor purchases an XYZ 8% $1,000 par value convertible bond which is convertible into XYZ common stock at $20 per share. To determine the number of shares that can be received upon conversion divide the par value by the conversion price. In this case $1,000 / $20 = 50 shares. At the time off issuance XYZ's common stock was most likely trading well below the conversion price of $20.
So why would you do the conversion? Remember, not only do the conversion terms mean you have to hold on to these bonds for some period before they can be favorably exchanged for stock, these bonds also feature a lower interest rate than straight bonds. How did a market form for these securities?
According to investment bankers at Tennessee-based Mercer Capital, the investor trades coupon income for upside potential. The conversion price may be parked at $20, but the market price changes almost every day. If the company is a drug maker and it announces a cure for Parkinson's disease, the share price could go from $15 to $20 in minutes. By the end of the day, there is no limit to how high it can go. If it goes up to $50, just to pick a number, the investor who can convert his debt into shares priced at $20 suddenly looks like a genius.
What Do Companies Get Out of It?
Meanwhile, the issuing company benefits too. Debt is almost always cheaper to issue than equity. Not only does the company get to issue debt instead of equity and thus keep its total cost of capital low, but it also issues that debt at a lower rate than it would have to if its bonds traded without a convertibility feature.
When the convertible securities are exchanged for the underlying common stock this lead to dilution in tne common shares, meaning there are suddenly more shares with the same rights to the company's assets and cash flows, which in turn means that each share is worth a little less.
Convertibles and Arbitrage
Convertible securities are tools used in arbitrage, the simultaneous buying and selling of a security. The purpose of arbitrage is to take advantage of small discrepancies in market prices.
If a stock is trading at $10 on the New York Stock Exchange and at $10.01 on the Pacific Stock Exchange, an arbitrageur - aided by a specialized computer application - can buy 1,000,000 shares in New York while selling 1,000,000 shares at the same time in San Francisco. He makes a one-cent profit 1,000,000 times, or $10,000, in one second.
So let's say the common stock price for the hypothetical pharmaceutical company (with the cure for Parkinson's) does not go to $50. It just goes to $20.01. An alert arbitrageur will spend $10,000,000 to buy 10,000 convertible bonds with the $1,000 face value. He converts them to 500,000 common shares (50 shares per bond times 10,000 bonds), each convertible at $20. He then sells those 500,000 shares for $20.01, making a one-penny profit 500,000 times, or $5,000 for doing almost nothing and taking no time to do it.
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