What Is Conversion?
In finance, conversion primarily refers to the act of exchanging one type of security for another, typically at the holder's option and under predetermined conditions. This process is most commonly associated with convertible securities, such as convertible bonds or preferred stock, allowing their holders to convert them into a specified number of common stock shares of the issuing company. Conversion is a key feature of these financial instruments, bridging characteristics of both debt securities and equity, thereby falling under the broader category of corporate finance. This mechanism provides investors with potential upside participation in the company's stock while retaining some of the downside protection of a bond.
History and Origin
The concept of securities conversion has a long history, with early forms emerging in the 19th century. Convertible bonds, for instance, were initially used to finance large-scale capital-intensive projects, particularly canals and railroads in the UK and the US.10 One of the earliest documented instances of a convertible loan dates back to the Ashton-under-Lyne Canal Company in England in 1798.9 In the Netherlands, the Amsterdam water company Duinwater notably issued convertible bonds in 1856.8
These instruments evolved as a means for companies to raise capital at potentially lower interest payments than traditional bonds, by offering investors the added incentive of participating in the company's future growth through the option to convert into shares. The structure allowed issuers to borrow at reduced rates in exchange for offering investors a call option on their equity.7 Over time, this financial innovation proved to be an essential tool for issuing firms, developing into a widely used instrument across various financial markets.6
Key Takeaways
- Conversion is the exchange of one security type for another, most notably convertible bonds or preferred stock into common stock.
- It provides investors with a blend of fixed-income stability and equity upside potential.
- Companies issue convertible securities to raise capital, often at lower borrowing costs, by offering an embedded conversion option.
- The decision to convert typically rests with the bondholders or preferred shareholders, based on the underlying stock's performance.
- Conversion can lead to dilution for existing common shareholders.
Formula and Calculation
The core of a security conversion lies in its conversion ratio, which dictates how many shares of common stock an investor receives for each convertible security.
The total value received upon conversion is calculated as:
For example, if a convertible bond has a conversion ratio of 20:1, it means one bond can be converted into 20 shares of common stock. Investors will assess this conversion value against the bond's face value and market price to determine the optimal time for conversion.
Another important concept is the conversion price, which is the effective price per share at which the convertible security can be converted into common stock. It is calculated as:
For instance, if a $1,000 convertible bond has a conversion ratio of 20, the conversion price is $50 per share (($1,000 / 20)).
Interpreting the Conversion
The interpretation of conversion centers on the financial implications for both the investor and the issuing company. For investors, the decision to initiate a conversion is typically driven by the underlying stock's performance. If the market price of the common stock rises significantly above the conversion price, the conversion value of the bond will exceed its bond floor (the value of the bond purely as a debt instrument). At this point, it becomes financially advantageous for the investor to convert the bond into shares, profiting from the increase in equity value. Conversely, if the stock price remains below the conversion price, the bondholder will likely choose to hold the bond, continuing to receive interest payments and eventually its face value at maturity, benefiting from the bond's downside protection.
For the issuing company, conversion impacts its capital structure. When convertible securities are converted, debt is reduced from the balance sheet, but the number of outstanding common shares increases. This increase in shares can lead to dilution of existing shareholders' ownership percentage and earnings per share. Companies often issue convertible securities with the expectation of future conversion, which can effectively lead to equity financing at a later stage, possibly at a premium to the current stock price.
Hypothetical Example
Consider XYZ Corp. which issues a $1,000 convertible bond with a 5% coupon rate and a conversion ratio of 25. This means each bond can be converted into 25 shares of XYZ Corp. common stock. The conversion price, in this case, is ($1,000 / 25 = $40) per share.
- Scenario 1: Stock price rises. If XYZ Corp.'s common stock price increases to $60 per share, the conversion value of the bond would be (25 \text{ shares} \times $60/\text{share} = $1,500). An investor holding this convertible bond would likely choose to convert it into common stock, realizing a $500 gain per bond (($1,500 \text{ conversion value} - $1,000 \text{ face value})).
- Scenario 2: Stock price falls or stays flat. If XYZ Corp.'s stock price drops to $30 per share, the conversion value would be (25 \text{ shares} \times $30/\text{share} = $750). In this situation, the investor would not convert, as the conversion value is less than the bond's face value. They would continue to hold the bond, receiving the 5% coupon payments and the $1,000 principal at maturity, as long as the company remains solvent.
This example illustrates how conversion provides an embedded option that becomes valuable when the underlying stock performs well.
Practical Applications
Conversion, particularly concerning convertible bonds, finds several practical applications in the financial world. Companies often use convertible securities as a financing tool, especially for those that may not have strong credit ratings or wish to raise capital without immediately diluting existing shareholders. By offering the conversion feature, they can often issue debt at a lower yield than a straight bond. This allows them to manage cash flow more effectively by reducing immediate debt servicing costs.
For investors, convertible securities are a part of various investment strategies. They offer a "hybrid" investment that provides fixed-income characteristics, such as regular interest payments and a return of principal, combined with the potential for capital appreciation through equity participation. This can be particularly appealing in volatile markets, as convertibles tend to offer some downside protection compared to pure equity, while still allowing participation in market rallies.
From a regulatory standpoint, the conversion of securities, particularly those affecting public companies, is subject to oversight. For instance, the U.S. Securities and Exchange Commission (SEC) provides guidance on convertible securities, addressing issues such as registration requirements for common stock that may be issued upon conversion.5 The SEC emphasizes that companies are required to disclose details of such arrangements in their filings, including the potential for share dilution.4 Additionally, tax authorities like the IRS also have specific regulations concerning the treatment of convertible securities and their conversion for tax purposes.3
Limitations and Criticisms
Despite their benefits, convertible securities and the conversion process itself have limitations and criticisms.
One primary concern for existing shareholders is the potential for dilution. When convertible bonds or preferred shares are converted into common stock, the number of outstanding shares increases, which can dilute the ownership percentage and earnings per share of existing common shareholders. This is particularly true if the conversion occurs at a lower effective price than anticipated or if a large number of convertibles are exercised.
From the issuer's perspective, while convertible debt offers lower interest rates initially, the eventual conversion means giving up a portion of future equity appreciation. If the company's stock performs exceptionally well, the company might have been better off issuing straight equity at a higher valuation, or straight debt with a higher interest rate but no equity give-up. Additionally, the complex nature of convertible securities can make their valuation challenging for both issuers and investors.2
Furthermore, the timing of conversion is often at the discretion of the holder, which can create uncertainty for the company regarding its future capital structure. While companies may include provisions like call options to force conversion under certain conditions, market conditions can still impact the decision-making process. The behavior of convertible bonds can also be influenced by factors like credit risk, which can affect their bond floor and overall attractiveness.1
Conversion vs. Option Exercise
While "conversion" and "option exercise" are closely related, particularly in the context of convertible securities, they are not interchangeable.
- Conversion specifically refers to the exchange of an existing security (like a convertible bond or preferred stock) into another type of security (usually common stock) based on predefined terms embedded within the original security. It's an inherent feature of the convertible instrument itself. The convertible security is the option, in a sense, to acquire equity.
- Option Exercise, in a broader sense, refers to the act of putting a financial option (like a call option or put option) into effect. An option contract is a separate derivative instrument that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) on or before a certain date. When an investor exercises an option, they are enforcing this right granted by a standalone contract.
In essence, conversion is a specific type of option exercise, where the "option" is bundled within a debt or preferred stock instrument. When an investor converts a bond, they are exercising the embedded equity option. However, not all option exercises involve the conversion of a previously issued security; many involve standalone derivatives traded on exchanges. The decision to convert is typically less about market timing in the same way a speculative option trade might be, and more about whether the underlying stock price makes it favorable to switch from a debt-like investment to an equity investment.
FAQs
What types of securities can be converted?
The most common types of securities that can undergo conversion are convertible bonds and convertible preferred stock. These are designed with an embedded feature that allows them to be exchanged for common stock. Less frequently, other forms of debt or hybrid instruments might have conversion features.
Who decides when a security is converted?
In most cases, the decision to convert rests with the holder of the convertible security (e.g., the bondholder or preferred shareholder). However, some convertible securities include provisions that allow the issuing company to force conversion under certain conditions, often when the underlying stock reaches a specified price level for a defined period.
What is the "conversion premium"?
The conversion premium is the amount by which the market price of a convertible security exceeds its conversion value. It reflects the value investors place on the convertible's fixed-income features (like regular interest payments and downside protection) over its immediate equity value. A positive conversion premium indicates that the convertible is trading at a price higher than the value of the shares it could be immediately converted into. As the stock price rises, the premium typically shrinks, and the convertible's price moves more in line with its underlying equity value, often due to arbitrage activity.
Does conversion always result in a profit for the investor?
No, conversion does not always result in a profit. The decision to convert is profitable only if the conversion value (the value of the common stock received) is greater than the investor's cost basis for the convertible security. If the underlying stock price falls significantly, the investor may choose not to convert and instead hold the bond to maturity to receive its face value, or sell it at its bond floor value. Investors should carefully review the prospectus for any convertible security before investing.