Diversify Your Portfolio With Convertibles

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Convertible securities are hybrid forms of debt and equity that offer investors the potential to convert their investment into shares of common stock. They are typically repaid at maturity and pay a rate of interest.

Convertible Bonds

The convertible bond market offers investors a blend of regular interest payments and potential capital appreciation from the underlying stock. They also provide downside protection that is lacking from investing in the underlying shares directly and can be an effective way to diversify a portfolio.

A convertible bond starts out working much like a conventional fixed income security, with an issuer paying interest periodically and then redeeming the principal at some point in the future for cash. A convertible bond’s investment profile is differentiated from a traditional bond by the embedded conversion option, which gives investors the right to convert the security into equity shares at a specific price and rate at some point in the future.

Vanilla convertible bonds are the most common convertible structure. These offer a vanilla coupon (periodic interest payment) and have a maturity date when the principal is due to be repaid in cash. At this time, the holder can choose to convert the bonds into shares or request redemption at par. The conversion options at this time will depend on whether the underlying share price is above or below the fixed conversion price.

Mandatory convertibles, on the other hand, require the bond to be converted into shares at the end of its life cycle. These bonds typically come with two fixed conversion prices, limiting the maximum amount that an investor could receive back in shares above the original par value of the bond.

Convertible Notes

Convertible notes are debt instruments that can be converted into equity at a later date. The note terms typically provide for interest to accrue as if the investor were taking out a regular loan and also include a discount rate that allows the investors to acquire shares in a subsequent equity investment round at a reduced valuation. This gives them an advantage over other investors in the same round and can significantly reduce their cost of capital.

Early stage startups often raise their first external funding using convertible notes rather than equity rounds. The reason for this is that it delays the valuation decision to a later date, when the company has more traction and can show real evidence of its worth.

The company can decide to convert the notes into equity when a future qualifying financing round occurs or on a specified date. This is a great flexibility for the startup, as it may not have a good understanding of its value at that point.

The notes typically have governance-related rights while they are outstanding, such as board observer rights and financial information rights, allowing the investor to monitor and protect their investment. They can also stipulate the conversion treatment at maturity or on an exit event (a repayment in cash or share swaps) and may provide for a most-favored nation provision, which prevents the company from issuing equity on more favorable terms while the convertible note is outstanding.

Convertible Securities

Convertible securities (both bonds and preferred stock) allow you to participate in the equity upside of a company while potentially mitigating a significant amount of the potential downside risk. You also gain the benefit of receiving a fixed income stream (a coupon payment in the case of convertible bonds, or a dividend in the case of convertible preferred shares) that is typically greater than that of common stock.

A key consideration in evaluating a convertible is its investment floor, which represents the minimum price below which a convertible should not fall based on its creditworthiness and conversion ratio. This figure is the hinge on which all other calculations rest, and determining its appropriate level requires rigorous research well above and beyond third-party credit ratings. The Calamos team utilizes proprietary modeling and research to establish a fair value price track for a convertible.

The conversion feature of a convertible is often sensitive to the price of its underlying common stock, and it will perform differently from its fixed income counterparts at various points in time. For instance, the more the market price of the underlying stock rises, the closer it will be to the conversion price, and the more sensitivity the convertible may have to stock volatility. Similarly, an increase in the interest rate environment will tend to make convertibles more bond-like and less equity-like.

Convertible Equity

Convertible securities provide investors with the ability to gain exposure to a company’s equity without having to take on the full equity risk. They are often less volatile than the underlying common stock and offer investors the opportunity to participate in the upside of price appreciation while providing downside protection, which reduces their overall market risk and enhances their diversification benefits.

Many companies need to raise some amount of capital between larger rounds of equity and a convertible is an ideal vehicle for this type of financing. This is especially true for early stage companies whose valuations have yet to be set and where the company may not be in a position to raise a priced equity round in a timely manner.

Unlike preferred shares, convertible debt does not give investors a voting right or board seat. Nevertheless, there are situations where the company needs to access this form of funding in order to quickly close a major customer transaction or to avoid missing a milestone growth event.

However, it is important to understand that financing a company with convertible bonds or securities runs the risk of significantly diluting a company’s EPS and future earnings potential in the event that the conversion ratio is higher than expected. In addition, servicing interest payments can strain cash flows and create a complex cap table that could deter future investors. To mitigate these risks, Oaktree’s Global Convertible team carefully analyzes a convertible issuer’s credit and business prospects, using traditional valuation modeling and direct conversations with the company’s management and industry experts.