What is Dividend Enhanced Convertible Stock?
Dividend Enhanced Convertible Stock is a preferred stock that provides the holder with premium dividends in addition to an embedded short put option and a long call on the issuing company's stock.
Understanding Dividend Enhanced Convertible Stock (DECS)
Dividend enhanced convertible stocks (DECS) obligate the holder to convert their security into the underlying company's common stock at some later time. For this reason, DECS basically function similarly to bonds that experience mandatory conversions to common stock at some point. A DECS’ mandatory common stock conversion time period is governed by the company that issues the offering, however conversion typically occurs within a three-to-four year span, following the initial purchase.
Unlike traditional zero-coupon convertibles, DECS provide an equity kicker and can be put to the issuer on certain dates, at prices reflecting the accumulation of the implied interest return. This put feature offers holders a measure of downside protection that limits an investor’s potential losses. In other words, the conversion comes at a predetermined fixed rate, and that conversion ratio begins to decrease once the price of the underlying shares reaches a certain level. But until that point, the conversion ratio is 1:1, and DECS shares may be issued at the same market price as the underlying stock.
DECS are not the only non-traditional convertible product that has come to market. Other similar models include:
- Preferred Equity Redemption Cumulative Stocks (PERCS)
- Preferred Redeemable Increased Dividend Equity Security (PRIDES)
- Automatically Convertible Equity Securities (ACES)
- Structured Yield Product Exchangeable For Stock (STRYPES)
Each of these hybridized models has its own set of unique risk and reward characteristics. But they share the same basic features, including an upside potential that is typically less than that of the underlying common stock, due to the fact that convertible buyers pay a premium for the privilege of converting their shares, and they enjoy higher-than-market dividend rates.
DECS, like most customized hybrid convertible models, originating from different investment banks, which benefit from these instruments, because unlike pure debt issuances like corporate bonds mandatory convertibles do not pose a credit risk later for the company issuing them, since they eventually convert to equity. Such convertibles also eliminate the downward pressure a pure equity would place on the underlying stock, since they are not immediately converted to common shares.