What Is a Mandatory Convertible?
A mandatory convertible is a type of convertible bond that has a required conversion or redemption feature. Either on or before a contractual conversion date, the holder must convert the mandatory convertible into the underlying common stock.
Mandatory Convertible Explained
There are two common ways a company can raise capital – equity issuance or debt issuance. When a company issues equity, its cost of equity is dividends to shareholders. Not all companies pay dividends, however, in which case, shareholders expect a return on investment determined by capital appreciation in the share price. The cost of debt for issuing debt or bonds is the periodic interest payments that are to be made to bondholders. A company’s decision on how to raise money to finance its capital projects depends on the accessibility or cost of each security issuance.
Sometimes, companies stray from pure debt or pure equity issues to gain flexibility in adjusting its capital structure or reducing its cost of capital. A company may choose to issue debt if general market conditions are not favorable to an equity issue or if a traditional equity issuance would otherwise place severe market pressure on the price of the existing shares in the market. If this is the case, the debt issued may have a mandatory convertible feature which will allow the debt to be converted into equity at a more favorable time. A bond with a mandatory convertible feature will be highlighted on the trust indenture at the time of issuance.
A mandatory convertible is a security that automatically converts to common equity on or before a predetermined date. This hybrid security guarantees a certain return up to the conversion date, after which there is no guaranteed return but the possibility of a much higher return. This differs from the standard convertible bond in which the holder has the option of exercising his or right to convert the fixed income security into shares at the issuing company. A normal convertible bondholder might choose to convert or to leave the bonds in his or her portfolio depending on the market conditions of the equity and bond market, providing a downside protection for the investor in the event that the share price of the company does not perform as expected.
Since mandatory convertibles strip the bondholder of any conversion options, investors are provided with higher yields than ordinary convertibles to compensate holders for the mandatory conversion structure. The issue price of the mandatory convertible at the time of issuance equals the price of the common stock. The trust indenture lists the conversion price, which is the price at which the debt securities are convertible into common stock at a premium to the issue price upon maturity. In actuality, two conversion prices are stated with a mandatory convertible – the first conversion price limits the price in which the investor would receive the equivalent of its par value back in shares, the second would delimit the price in which the investor will earn more than par. If the stock price is below the first conversion price the investor would suffer a capital loss compared to his or her original principal investment. Instead of the conversion price, the conversion ratio might be stipulated instead; the conversion ratio is the number of shares that an investor can expect to have each par value bond converted into. This ratio changes depending on the issuing company’s stock price.
The application of mandatory convertible bonds also applies to mandatory convertible preferred shares, in which case, preferred shareholders must convert their shares to common stock at a specified date.