Hung convertibles are convertible securities where the share price of the underlying security is well below the conversion price, making it unlikely that the securities will be converted into common stock. Since unconverted securities must be repaid at face value, most issuers aim to avoid their convertibles from being hung.
Key Points to Remember
- Convertible securities can be repaid either in money or the issuing company’s stock, subject to certain conditions.
- Hung convertibles are convertible securities where the share price of the underlying security is significantly below the conversion price, making conversion into common stock improbable.
- With limited prospects for conversion, hung convertibles, also called busted convertibles, trade more like debt instruments.
- Companies generally prefer to avoid hung convertibles since these obligations need to be repaid in cash.
- To rectify a hung convertible situation, a company must improve its fundamentals to boost the common stock price to the conversion level.
Understanding Hung Convertibles in Depth
Convertible securities, such as bonds, notes, or preferred stock, offer the flexibility to convert into the common shares of the issuing company at a specified price and date. These securities are often issued by companies with low credit as a cost-effective method of raising funds.
Hung convertibles occur when these securities are unlikely to be converted into stock, typically when the cost of conversion outweighs the underlying stock price. They act more like debt instruments than quasi-equity securities due to their slim conversion chances. The term can also apply when:
- The issuer cannot enforce conversion until the common stock hits a pre-defined price level.
- The call date is distant in the future.
Thus hung convertibles resemble other debt instruments. Once the underlying stock price reaches a beneficial conversion level, they tend to behave like equities.
Real-World Example of a Hung Convertible
Hung convertibles can be structured distinctively as bonds secured with collateral or debentures backed by the issuer’s commitment to fulfill obligations. For instance, imagine a convertible debenture with a $1,000 face value convertible into 100 shares, equating to a conversion price of $10 per share. If the stock price is $4, this debenture is a classic hung convertible, mostly if it matures soon.
Such a debenture will be priced similar to debt instruments, dictated by factors like its coupon rate, maturity, current market interest rates and yields, and the issuer’s credit rating. To tackle a hung convertible issue, the issuing company must boost its fundamentals like revenue growth, operating margins, or return on invested capital to elevate the stock price near the conversion level.
Benefits and Challenges of Hung Convertibles
Many investors see hung convertibles as offering a balance, combining a bond’s income-producing, stable price qualities with the conversion option that could turn into common stock with higher capital appreciation and lower sensitivity to interest rates.
Hence, investors continue to earn coupon payments until maturity or conversion. For equity investors, they represent an opportunity to reap benefits in rising markets while providing more downside protection during volatile periods compared to owning common stock alone.
However, there are drawbacks. Convertibles, due to their conversion feature, offer lower coupon rates than comparable maturity and credit quality bonds. The difference, according to assets manager Calamos Investments, spans 300 to 400 basis points. Poor stock performance of the issuer results in the investor being left with lower-paying bonds.
Critical Considerations
Valuing convertibles entails analyzing factors affecting bonds, like interest rates, and stock impacts, such as earnings growth, together. Convertible bonds trading near their investment value are more influenced by interest rates. Those closer to their conversion value will be impacted more by the issuing company’s fundamentals.
Related Terms: convertible securities, debt instruments, bearer bonds, stocks.
References
- Calamos Investments. “Convertible Securities”.
