What are Hung Convertibles
Hung convertibles are convertible securities where the share price of the underlying issuer is well below the conversion price, making it unlikely the securities will convert into common stock. The term also describes two other instances where the likelihood of conversion is low: if the issuer is unable to force conversion until the underlying common stock reaches a pre-defined price level, or because the call date is still far away. Due to their limited prospects for conversion, hung convertibles, also known as busted convertibles, trade more like debt instruments than quasi-equity securities.
BREAKING DOWN Hung Convertibles
Hung convertibles can take the form of bonds, which are backed by collateral, or debentures, which are dependent on the promise of the issuer to pay its obligations. For example, consider a convertible debenture with a face value of $1,000 that can be converted into 100 shares, for a conversion price of $10. If the price of the underlying stock is $4, this debenture would be considered a hung convertible, especially if it matures in a relatively short period. Such a debenture would therefore be priced as a debt instrument, with its pricing determined by several factors including its coupon rate, maturity, current market interest rates and yields, and the issuer's credit rating.
Some investors view hung convertible securities as the best of both worlds. They have the income-producing and stable price qualities of a bond plus the conversion feature that can provide the potential to gain shares of common stock, which have historically provided greater capital appreciation and been less sensitive to interest rates than bonds. In other words, an investor gets paid to wait by earning coupon payments up until maturity or conversion into common equity. For an equity investor, convertibles can offer a degree of participation in up markets and more downside protection in turbulent markets than owning the common stock outright.
Limitations of Hung Convertibles
But hung convertibles come with drawbacks as well. Due to the conversion feature, convertibles pay lower coupon rates than bonds of the same maturity and credit quality. Convertibles investment manager Calamos Investments pegs this difference at 300 to 400 basis points, quite a spread in today’s low interest rate environment. And if the stock of the issuer performs poorly, the investor will be left with a lower paying bond.
Valuing convertibles is also a complex exercise since factors that impact bonds, such as interest rates, and factors that impact stocks, such as earnings growth, must be analyzed in tandem. According to Calamos, the price of a convertible trading closer to its investment value, or the value of an equivalent non-convertible bond, will be more influenced by interest rates than one trading closer to its conversion value. In general, however, a change in the fundamentals of the issuing company, for better or worse, will have the greatest impact on a convertible’s price.
To solve the problem of a hung convertible, a company therefore would need to improve its fundamentals, such as revenue growth, operating margins or return on invested capital, to spur the common stock high enough to reach the conversion price.