In this article you will learn everything you need to know about convertibles, such as what a convertible is and how to trade convertibles.
Buying a convertible means lending money to the issuer, usually a company, much like a bond. But unlike a bond, a convertible gives the holder the right to convert the loan into shares in the company, on specific terms. The holder can therefore choose between getting their capital back when the term expires or becoming a shareholder.
A convertible can also pay interest during its term, but its main feature is the option to convert the debt into shares. All convertibles have terms that govern how and when conversion may take place. Convertibles are often issued as part of a company's capital raising, but are not directly linked to a new share issue.
How does trading in a convertible work?
An example of trading in a convertible is set out below:
- Anders buys a convertible worth SEK 10 million in a company. The convertible works as a loan to the company, and Anders receives 3% annual interest on his investment.
- The convertible gives the option to convert the value of SEK 10 million into 100,000 shares in the company at a price of SEK 120 per share, if the share price at the end of the term is at or above SEK 120.
- When the convertible's term ends, the company has done well. Anders then chooses to convert to shares, since that earns him the most. The nominal (original) value is SEK 10 million, while the shares are worth SEK 12 million at the time of conversion.
Why do companies use convertibles to raise capital?
Companies use convertibles to raise capital in order to:
- Obtain more money without an immediate new share issue and thereby avoid direct dilution of the shares. The convertible initially works as a loan, which means that the dilution of shareholders' stakes only happens if investors choose to convert to shares at the end of the term.
- Offer investors an interest rate that can often be lower than for a traditional bank loan, depending on the company's creditworthiness. For companies with good growth potential, convertibles can be a cheaper alternative to other forms of financing.
- Attract investors and venture capitalists by combining interest payments with an option to convert the convertibles into shares. Investors thereby get both security in the form of interest and potential for an increase in value if the company does well.
What types of convertibles are there?
Below we describe the most common convertibles.
- Classic convertibles: These give the holder the right to convert the loan into shares at the end of the term or at other specified times. Conversion is voluntary and based on the holder's choice.
- Mandatory convertibles: These force the investor to convert the loan into shares at the end of the term or if certain conditions are met, for example if the share price reaches a certain level.
- Immediate convertibles: These can be converted into shares at any time during the term, giving the holder flexibility to choose when to convert.
- Long-term convertibles: These have a longer term, usually between 5 and 10 years, and are often designed for long-term investors.
In this article we focus mainly on classic convertibles, as they are by far the most common.
Advantages and disadvantages of convertibles for investors
Advantages
- High flexibility, as the owner can choose either to get their capital back or to convert their stake into shares at the end of the term, depending on the convertible's terms.
- If the company does well and the share price rises, the investor can earn a higher return on their investment by converting to shares.
- The investor usually receives interest on their loan during the term, which provides some ongoing return, although some convertibles may be interest-free.
Disadvantages
- The investor takes on a credit risk, since the company may not be able to repay the loan in full or at all if things go badly.
- If the share price falls and does not reach the conversion price during the term, the investor only receives the interest, which is often lower than the average stock market return.
Frequently asked questions
Below we answer common questions about convertibles.
What is the nominal amount of a convertible?
The nominal amount of a convertible is the original value the convertible had when it was issued by the company. This amount is what is repaid to the investor if the convertible is not converted into shares, and it is used as the basis for calculating any interest during the term.
What does convertible mean?
A convertible is a debt instrument that gives the holder the right to convert the loan into shares in the company at a later date, on predetermined terms.
What does a convertible agreement contain?
A convertible agreement contains provisions on the loan amount, term, coupon rate (if interest is paid), conversion price, and the conditions and times at which the investor is entitled to convert the loan into shares. The agreement may also contain specific restrictions or risk factors linked to the conversion.
Is a convertible a good investment?
A convertible can be a good investment for investors seeking a combination of interest and the possibility of converting to shares. It offers a potential return through interest and a chance of capital growth if the share price rises, but the risks vary depending on the company's creditworthiness and market developments. Convertibles carry higher risk than bonds but lower risk than a direct investment in shares, which makes them suitable for investors seeking a balanced level of risk.
What is a reverse convertible?
A reverse convertible works the opposite way to a classic convertible. With a reverse convertible, it is the company that decides whether the convertible will be repaid in cash or in shares at the end of the term. The investor usually receives a higher interest rate as compensation for the risk that the company may choose to repay in shares, particularly if the share price has fallen below a certain level.
