What Is a Forced Conversion?
Forced conversion occurs when the issuer of a convertible security exercises their right to call the issue. In doing so, the issuer forces the holders of the convertible security to convert their securities into a predetermined number of shares.
Oftentimes, issuers choose to initiate a forced conversion when interest rates have declined significantly since their convertible security was issued. In such a scenario, the forced conversion benefits the security issuer because it allows them to reduce their interest burden and potentially issue new debt securities at a lower interest rate.
Key Takeaways
- Forced conversion is the practice of converting debt into equity at the demand of a security issuer.
- An issuer may demand conversion or call in callable securities in response to falling interest rates, effectively allowing the issuer to refinance debts.
- Investors run the risk of being subject to forced conversions when they purchase callable convertible securities.
- They will then have reinvestment risk as new securities will tend to offer lower yields than the called securities.
- Because forced conversions are a risk to investors, callable securities tend to offer slightly higher yields compared to similar non-callable alternatives.
How Forced Conversions Work
Forced conversions are one of the risks faced by buyers of convertible securities, which are a type of debt instrument that can be converted into shares of underlying stock.
For example, a convertible bond might give the investor the right to exchange their debt instrument for a certain number of shares in the company issuing the bond. Depending on how the price of the shares changes over time, the bondholder may feel that they are better off exercising their conversion privilege and becoming a common shareholder.
In some cases, convertible securities are also callable, meaning that they give the issuer the right to force the security holder to convert their holdings. In the case of convertible bonds, this would prompt a forced conversion of the bonds into a predetermined number of common shares. Since forced conversions are initiated at the discretion of the security issuer, they are generally not favorable to investors. For this reason, securities that can be called by the issuer generally trade at a discount relative to comparable securities that do not have this provision.
The Conversion Ratio
When deciding to purchase a convertible security, the investor will consider the security’s conversion ratio. The conversion ratio specifies how many shares of the issuing company the investor would receive if a forced conversion is triggered.
For instance, a convertible bond with a 10-to-1 conversion ratio would allow the bondholder to exchange each $1,000 of par value into 10 shares of stock. If the stock price rises after the bond has been purchased, this would make it more tempting for the bondholder to exercise this option.
Likewise, it might also encourage the convertible bond issuer to call the bond, triggering a forced conversion.
Example of a Forced Conversion
Michaela is a retail investor with a portfolio of convertible bonds. Her largest single position is in the convertible bonds of XYZ Enterprises, which she purchased with a conversion ratio of 25-to-1. Michaela has invested $100,000 into XYZ’s convertible bonds, and the company’s shares were trading for $40 at the time that she purchased them.
Recently, Michaela received notice from XYZ that they had elected to call her convertible bonds, triggering a forced conversion of her debt into equity. Because the bonds offered a conversion ratio of 25 shares for every $1,000 of par value, this means that Michaela was forced to exchange her $100,000 of XYZ bonds for 2,500 shares of XYZ common stock. At the time of the forced conversion, XYZ’s shares were still trading at $40, meaning that the value of Michaela’s common shares was still $100,000, the same as before the conversion.
Michaela reasoned that XYZ probably decided to force the conversion because interest rates had declined significantly since the convertible bonds were issued. By forcing the conversion, XYZ relinquished their existing debt, freeing themselves to borrow new funds at lower interest rates. Michaela, meanwhile, has the option to either keep her common shares or else sell them and invest the proceeds elsewhere.
Advantages and Disadvantages of Callable Convertible Bonds
A callable bond is a debt instrument issued by a company that has an embedded option allowing the issuer to "call back" or redeem those bonds before they mature. Because this option has potential value for the issuer and poses a potential risk for investors, callable bonds often have higher yields than equivalent bonds that are not callable.
The main risk for investors is reinvestment risk. This is because an issuer will generally exercise the call option only if they believe they can issue new bonds and borrow at a better (i.e., lower) interest rate. Bondholders, however, who have their bonds called will be forced to consider new bonds with lower yields. Therefore, a callable bond investor may accept this risk in return for a higher yield especially if they believe that interest rates will hold steady or rise over the bond's maturity.
Note that with a callable convertible bond that is also callable, there are two embedded options. One is favorable for the investor: they can convert their debt into common stock at a certain price and amount. Therefore, if the stock rises, it benefits the bondholder.
Pros and Cons of Callable Convertibles (from the perspective of bondholder investors)
Pros
Option to convert the bond into stock
The call feature of the issuer increases the yield over other convertibles
Cons
The call option can be used by the issuer if rates fall causing reinvestment risk
If called, there could be an unwanted forced conversion
What Is the Difference Between a Convertible Bond and a Callable Bond?
A convertible bond is one that can be changed into the issuer's common stock. A callable bond is one that can be redeemed early by the issuer. The former is an option that favors the investor, while the latter has potential value for the issuer. Some bonds are issued as both callable and convertible, which can result in a forced conversion for the investor of the bonds into shares when they are called in.
Are Treasury Bonds and Notes Callable?
No. In general, Treasuries are not callable by the government.
Why Are Convertible Bonds Attractive to Investors?
Investors may find convertible bonds attractive because, as debt instruments, they are safer than a bond and will tend to pay regular interest payments. They can also be converted into the issuer's stock, which can provide a windfall to investors if the price of the stock rises substantially before the bond matures.
What Is a Mandatory Convertible Bond?
A mandatory convertible bond has a requirement that the bond be converted into shares by the investor, rather than having the option to do so. Because the issuer's stock may be higher or lower than when the bonds were issued, there is some risk to the bondholder, resulting in higher yields than a normal convertible.
