What Is a Convertible Subordinate Note?

A convertible subordinate note is a short-term debt security issued by a company that can be exchanged for its common stock at the discretion of the bondholder. It is a short-term convertible bond, but which ranks below other, more senior loans (it is junior to other debt).

In the event the issuer becomes bankrupt and is forced to liquidate its assets, a convertible subordinate note will only be repaid after other debt securities have been paid. As with all corporate debt securities, however, the note will have priority of being repaid before stock.

Key Takeaways

  • Convertible subordinate notes are short-term convertible bonds issued by a company that may be converted into company shares.
  • Subordinated debt is debt that is repaid after senior debtors are repaid in full, making it somewhat riskier than more senior debts but less risky than for stockholders.
  • If the convertible note is exchanged for shares, the investor loses their intermediate priority of being repaid in the event of a bankruptcy.

Understanding Convertible Subordinate Notes

A convertible is a type of security that can be converted into common stock at the holder's option. Convertible securities can be exchanged for common stock at a stated conversion price. The number of common shares that can be obtained is determined by the conversion ratio, which divides the par value of the security by the conversion price. For example, assume the conversion price at the time of issue for a convertible subordinate note is $50. Each $1,000 par value note, then, could be exchanged for 20 shares of common stock ($1,000 / $50 = 20 shares).

The subordinate aspect of the note describes its ranking among other loans. As a subordinate debt, it is considered a junior debt, one that will not be paid until other, senior debt holders are paid in full. A convertible subordinate note, then, is a debt security that is both convertible to common stock at some point in the future and junior to other debts. In the event that the company becomes insolvent, however, convertible subordinate note holders rank ahead of shareholders for capital recovery. Because the holder has the option to convert to stock, the note tends to offer a lower rate of return. In general, the more valuable the conversion feature, the lower the rate of return.

Convertible subordinated notes tend to move in tandem with the price of the common shares. If share prices rise, the note's value will also rise. If the ordinary share price fluctuates significantly, then the price of the convertible notes is also likely to be volatile in turn. Consequently, convertible notes offer the possibility of significant capital gains (or losses) unlike some other fixed-income securities that tend to be less sensitive to equity markets.

Converting Convertibles

Conversion can be either voluntary or forced. A voluntary conversion is initiated by the holder and can occur at any time up to the expiration of the conversion feature. An investor that does not convert his or her notes to equity will receive the notes' face value in cash at maturity. The specific dates that the note holders can exercise their rights to convert their securities during the term life of the note can be found in the trust indenture.

A mandatory or forced conversion is initiated by the issuing company and can occur at any point in time. A company may, for example, exercise its call privilege on the convertible security. This may be done to remove long-term debt from its balance sheet without having to redeem bonds for cash. To encourage bondholders to convert their bond holdings, a company can increase its dividend on common stock so that holders are better off owning the common stock.