Hung Convertibles

Introduction

Convertible bonds are a unique investment instrument that combines the features of both debt and equity. They offer investors the opportunity to benefit from potential stock price appreciation while providing downside protection through the bond component. However, not all convertible bonds are created equal. In this article, we will explore the concept of “hung convertibles” and their implications for investors.

What are Hung Convertibles?

Hung convertibles, also known as “hung deals” or “hung bonds,” refer to convertible bonds that have not been fully converted into equity by their maturity date. This means that the bondholders have chosen to hold onto their bonds instead of converting them into shares of the underlying company.

Typically, convertible bonds have a conversion ratio that determines the number of shares an investor will receive upon conversion. If the stock price rises above the conversion price, bondholders have the option to convert their bonds into equity. However, if the stock price remains below the conversion price, bondholders may choose to hold onto their bonds and receive the fixed interest payments until maturity.

Reasons for Hung Convertibles

There are several reasons why bondholders may decide to hold onto their convertible bonds instead of converting them:

• Market Conditions: If the stock price of the underlying company is not performing well or is expected to decline further, bondholders may prefer to hold onto their bonds and receive the fixed interest payments.
• Conversion Premium: The conversion premium is the difference between the conversion price and the current stock price. If the conversion premium is high, bondholders may choose to hold onto their bonds in anticipation of a future increase in the stock price.
• Dividend Payments: If the underlying company pays regular dividends, bondholders may prefer to hold onto their bonds and continue receiving the fixed interest payments instead of converting into equity and potentially missing out on dividend income.

Implications for Investors

For investors considering investing in convertible bonds, understanding the concept of hung convertibles is crucial. Here are some implications to consider:

• Lower Conversion Ratio: When a significant number of bondholders choose not to convert their bonds, the conversion ratio decreases. This means that each bondholder will receive fewer shares upon conversion, reducing the potential upside if the stock price appreciates.
• Increased Bondholder Influence: With a higher proportion of bondholders compared to equity shareholders, the influence of bondholders on company decisions may increase. Bondholders may have the power to influence dividend policies, capital allocation decisions, or even corporate governance.
• Reduced Liquidity: Hung convertibles can result in reduced liquidity in the underlying stock. If a large number of bondholders decide to hold onto their bonds, there may be fewer shares available for trading, leading to wider bid-ask spreads and potentially higher transaction costs.

Case Study: XYZ Corporation

To illustrate the impact of hung convertibles, let's consider a case study of XYZ Corporation, a technology company that issued convertible bonds with a conversion ratio of 10:1. The bonds had a maturity of five years and a conversion price of $50 per share.

At the time of issuance, XYZ Corporation's stock price was $45 per share. Over the next five years, the stock price fluctuated between $40 and $60 per share. However, due to market conditions and a high conversion premium, bondholders chose to hold onto their bonds instead of converting.

As a result, at maturity, only 30% of the convertible bonds were converted into equity. This led to a lower conversion ratio of 3:1 for the remaining bondholders. If the stock price had appreciated significantly, the bondholders who held onto their bonds would have missed out on potential gains.

Strategies for Dealing with Hung Convertibles

Investors who find themselves holding hung convertibles have a few strategies to consider:

• Hold and Collect Interest: If the underlying company's financial health remains stable and the fixed interest payments are attractive, bondholders may choose to hold onto their bonds until maturity and collect the interest income.
• Sell in the Secondary Market: Bondholders can also choose to sell their bonds in the secondary market if they believe that the stock price is unlikely to appreciate significantly. This allows them to exit their position and potentially invest in other opportunities.
• Engage with the Company: Bondholders can actively engage with the company's management and other stakeholders to influence decision-making. This can include advocating for changes in dividend policies, capital allocation strategies, or even pushing for a conversion offer at a more favorable ratio.

Conclusion

Hung convertibles present unique challenges and opportunities for investors in the convertible bond market. Understanding the reasons behind bondholders' decisions to hold onto their bonds instead of converting is crucial for making informed investment decisions. While hung convertibles may result in a lower conversion ratio and reduced liquidity, they also provide bondholders with the potential for continued fixed interest payments and increased influence over company decisions. By considering the implications and exploring appropriate strategies, investors can navigate the world of hung convertibles with confidence.