Last week I was speaking to a colleague who was reviewing their pension and had seen the term ‘convertible security’ but didn’t know what it meant. A convertible security is essentially just a type of investment that can be ‘converted’ into another. For example, a convertible bond paying 5% could come with an option to be converted into common equity under certain conditions.
Let’s say that a company’s board with a share price of £1 per share wants to raise additional capital by issuing a bond to the market. Based on the company’s credit rating and market conditions, the CFO determines that to fill the bond, the company should offer 6% interest. As a savvy CFO, however, he also presents the board with an alternative option of issuing the bonds at 4.5%, with a conversion option at £2.50 per share. If the board wanted to raise £10,000,000, this would represent an annual saving of £150,000.
As a result, if an investor had filled all £10,000,000 of the bond, they would receive interest payments of £450,000 a year instead of the £600,000 a year payable on the non-convertible security. If the share price rose to £3 a share, they would also make additional capital gains from being able to convert their investment into shares costing only £2.50.
This potential for capital gains is the fundamental reason that investors are willing to accept a lower rate of interest on convertible securities. Investors are generally willing to accept lower returns due to the potential for sharing in the profits from the growth in value of a company’s common stock.
I know about convertible bonds, but I also heard about convertible preferred shares; what are they?
Convertible preferred shares are similar to convertible bonds, in that they are one form of security that can be ‘converted’ into another under certain conditions. Traditionally offered as a fixed-income security (an investment that pays a regular, fixed level of income), the securities can be converted into common stock after a pre-determined length of time or on a specific date.
As the shares are also ‘preferred’, the shareholders receive their income before holders of the common stock and are also placed in a ‘preferred’ position in the event of the company being liquidated, helping to mitigate the risk of capital loss whilst still providing the option to convert to regular shares in the event of the company being successful.
Do I invest in convertible securities?
Although I invest in listed shares, I leave the selection of bonds and more esoteric investment options to professionals in those fields. As a result, I don’t directly hold any convertible securities, but do hold a Convertible Security Investment Trust. My knowledge of bond investing is more limited than my understanding of equities, and specialist options such as convertible securities require extra analysis.
My preference is generally to invest directly in companies which I believe to have a bright financial future, but I see the value in diversifying across a range of financial securities that act in different ways. Generally speaking, bonds have been some of the poorest performing assets I’ve held, but as interest rates fall, their potential for capital appreciation can be significant.
In the current environment of rock-bottom interest rates, however, I consider the risk of directly holding bonds to outweigh the potential benefits. As interest rates rise, bond prices will fall (after all, why hold a 3% bond when you could put money in the bank at 4%?). As a result, I believe that relying on a bond-trading expert through an ETF or Investment Trust to be far preferable to trying to manage that risk directly.