What it means
A normal convertible bond gives the holder the choice to swap into shares, while a mandatory convertible removes the choice. At maturity, usually after about three years, the security converts automatically.
Until then, the investor collects a dividend or coupon that is often higher than the dividend on the common shares. The conversion ratio is the number of shares received per security.
Most mandatory convertibles use a structure with two price points, so the ratio changes depending on where the share price finishes. If the price is low, the investor gets more shares, and if it is high, the investor gets fewer shares.
Companies issue these securities to raise capital that will become equity, often when they want to improve their balance sheet without selling shares immediately at a low price. Rating agencies may give partial equity credit for the instrument, which can help the issuer's credit profile.
The threshold price is usually set at a premium to the share price on the issue date, so the issuer effectively sells shares at a higher price than the market offers today. For the investor, the trade-off is a higher income than the common shares but a capped share of any gain.
If the share price rises far above the upper threshold, the investor receives fewer shares and misses out on some upside. If the price falls below the initial price, the investor receives the maximum number of shares, which are worth less than the original investment.
The detail varies, so a reader should consult the prospectus for the exact ratios and thresholds. The tax treatment and any early conversion features also differ between issues.
In practice
Real-world examples.
Example
A utility company issues $500,000,000 of mandatory convertible preferred stock to fund a new power plant. Investors receive a 6% dividend for three years, then the securities convert into common shares. The utility can finance construction while it waits for the plant to earn revenue.
Example
A bank needing to strengthen its capital sells mandatory convertible notes to institutional investors. The notes convert on a set date, adding to the bank's common equity. Regulators may count part of the proceeds towards capital requirements.
Example
A technology company uses a mandatory convertible to fund an acquisition without immediately issuing a large number of shares. Existing shareholders are diluted only at conversion, spreading the impact over time. The share count rises only when the conversion date arrives.
Formula
Calculation
Maximum ratio = Face value / Initial price
Minimum ratio = Face value / Threshold price
Shares received = Maximum ratio if price is at or below the initial price; Face value / Share price if between the two prices; Minimum ratio if at or above the threshold price
A security has a face value of $100, an initial price of $20 and a threshold price of $25. The maximum ratio is $100 / $20 = 5 shares and the minimum ratio is $100 / $25 = 4 shares. If the share price is $18 at conversion, the holder receives 5 shares worth 5 x $18 = $90. If the price is $30, the holder receives 4 shares worth 4 x $30 = $120, which is a $20 gain, but less than the $150 that 5 shares would have been worth.Case study
Seen in the real world.
Ridgeway Energy is an illustrative, fictional power company that issued a three-year mandatory convertible at $100 per security. Its initial price was $20 and its threshold price was $25, with an annual dividend of 6%.
At conversion, the share price had risen to $28, so each holder received 4 shares worth $112. Investors earned the dividend plus a gain of 12%, but they gave up the extra upside that a direct purchase of 5 shares would have produced.
In this illustrative story, the company gained permanent equity capital and the investors gained income. The example shows why the pricing thresholds are as important as the headline dividend.
Watch out
Common mistakes.
- Treating a mandatory convertible like an ordinary convertible, when the holder has no option to keep the security or ask for cash.
- Overlooking the cap on upside, which means that holders gain less than full share price growth above the threshold.
- Assuming it is low risk because it pays a high dividend, when the share price at conversion can fall well below the original investment.
Questions
People also ask.
What is the main difference from a convertible bond?
A convertible bond gives the investor a choice to convert, but a mandatory convertible must convert on the set date.
Why do issuers like them?
They raise capital that becomes equity and may receive partial equity credit from rating agencies.
Do holders always receive the same number of shares?
No, because the number depends on the share price at conversion, within the minimum and maximum ratios.
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