Convertible Securities – What are the Types & Advantages?

What are convertible securities?

As the name suggests, convertible securities are financial instruments that can be converted from one form to another. These include preferred stocks and convertible bonds which can be converted to equity shares (common stock). Convertible securities are issued by large entities with the purpose of raising funds, and they are the ones who decide when these securities will get converted.

These securities pay a fixed interest, which is a lower return than non-convertible securities. The reason is that investors accept temporarily low returns as they stand to benefit more from the conversion of these securities in the future. The conversion price offered is also set above the market price of its equity shares.

What are the types of convertible securities?

Before we dive into the types of convertible securities, it is important to know that these securities have two features in common:

• Fixed Coupon: All holders of convertible securities receive a fixed interest payment on their investment.
• Pre-defined Conversion Ratio: At the time of issue, companies fix how many shares each convertible security will yield upon maturity.

There are two types of convertible securities:

1. Convertible Bonds

These are debt securities typically issued by corporates and governments to garner investor funds for a specific time period. These convertible securities have a fixed coupon, which is paid to the investors. Upon maturity, investors can convert these bonds into equity shares based on the pre-set conversion ratio. Should investors decide to not convert the bonds at the time of maturity, the face value is repaid to them.

As mentioned earlier, convertible bonds pay lower interest than non-convertible bonds. This is why companies issuing convertible bonds tend to prefer these financial instruments as they have to disburse lower pay-outs before their shareholding begins to dilute at maturity.

2.Convertible Preference Shares

Preference shares differ from common equity shares on two aspects i.e., voting rights and preference on pay-outs. This convertible security does not receive voting rights like common shares but gets preference during dividend payments and other repayments at the time of asset liquidation.

As is with convertible securities, preference shares also receive dividends at a fixed percentage and these can be converted into common shares upon maturity. Convertible shares are generally given to angel investors, and when these get converted, the voting rights kick in & the preference treatment expires.

Advantages

• Ease of conversion: Investors in these securities can have a hassle-free conversion into another form of investment. Moreover, this translates into the conversion of risk from one financial instrument to another. E.g., when a bond converts into an equity share, the potential return over the long term becomes significantly higher.
• Taxation benefits: Some convertible securities are eligible to avail tax benefits under the Income Tax Act. Generally, the interest received on such securities is not taxed. However, it is important to note that these benefits are not applicable once the conversion into common equity shares is done.

• Dilution risk: A company’s objective when issuing convertible securities is fundraising, but when the conversion happens upon maturity, it results in the dilution of its shareholding. Excess dilution is possible, and it may even lead to the loss of ownership. Moreover, voting rights are equally important, and distributing them among a larger shareholder base could prove to be detrimental to the company.
• EPS dilution: When convertible securities are issued, the earnings-per-share (EPS) decreases as the number of shareholders upon conversion increases. Lowering EPS may result in the company being able to find it difficult to secure any line of credit from any financial institution.

Who should consider investing in convertible securities?

Investors in convertible securities receive a fixed dividend pay-out until the time of maturity. This in turn means that those who wish to receive a stable temporary income can opt for these investment vehicles.

This investment method is also suitable for those who are interested in establishing a long-term source of income. This is because the scope for making larger gains increases when these securities become eligible for conversion. Equity shares of companies on a fast-growth track with a good amount of cash flow yield significantly greater returns with time.

While the above positives are true, it must be noted that a functioning knowledge of the stock market is equally essential as the decision to convert these securities depends on the ongoing market trends. Investment decisions such as this can be made with relative ease if due diligence is done by the investors.

FAQs

Why are convertible securities issued?

Companies and institutions issue these investment vehicles in order to raise funds while giving out lower interest payments. This gives the company some breathing room before its shareholding dilutes further.

Can I choose when to make the conversion into common equity shares?

No. At the time of issuing, the institution decides the conversion ratio (how many shares per convertible security), the coupon (the fixed interest payment), and the time when these securities become eligible for conversion.