What is a Forced Conversion
Forced conversion occurs when the issuer of convertible securities exercises the right to call the issue. By calling the issue, the originator forces the investors to convert their securities into a predetermined number of shares.
An issuer may consider forcing a conversion if interest rates decline significantly. They may also push the call if the price of the underlying security is above the conversion price. Forced conversions are generally detrimental to the holders of the product.
BREAKING DOWN Forced Conversion
Forced conversions occur with convertible securities. Convertible security investments can turn into another form, such as shares of the underlying stock. Convertible bonds or convertible preferred stock are examples of some common convertible securities.
In the case of convertible bonds, the security pays a coupon payment of a fixed amount at regular intervals until the bond reaches maturity. It carries a specific price at which conversion into stock may happen. In most cases, the holder of convertible securities has the right to determine when and if to convert. The bond's originator can typically turn whenever they choose after the conversion date. The same is not true if the issuer has included a forced conversion call feature into the bond.
Companies issuing the securities sometimes want the ability to force the investor's hand and make the hold the underlying product. To do this, they will add a call feature that allows the company to redeem the bonds based on specific criteria. Frequently, bonds are callable when they are at or near the conversion price. The calculation of the conversion price is at the time of issue and is a ratio. This ratio, located in the bond's indenture or the security's prospectus, outlines the situations for making the call. For called securities, the investor will receive the return of capital or common stock in an amount equal to the initial investment.
Example of a Bond Conversion
The conversion ratio also called the conversion premium would determine how many shares will change. Shown as a ratio or as a price it is specific to the bond.
If a bond has a ratio of 45:1, it means the $1000 bond equals 45 shares of the underlying. You may see this rate listed as a percentage premium, such as 5-percent. This premium means the investor who converts into shares at the market price when they bought the bond, plus a 5% premium. That market price could be different than the current price for the underlying.
Companies will execute a forced conversion to eliminate debt. In this case, bond debt converts to equity. After a forced conversion, the company will issue additional shares, which dilutes the value of those already in the marketplace.