Convertible security

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A convertible security is a security— usually a bond or a preferred stock— that can be converted into a different security—typically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs.[1]

Companies generally issue convertible securities to raise money. Companies that have access to conventional means of raising capital, such as public offerings and bank financings, might offer convertible securities for particular business reasons. Companies that may be unable to tap conventional sources of funding sometimes offer convertible securities as a way to raise money more quickly.[1]

In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price. The convertible security financing arrangements might also include caps or other provisions to limit dilution (the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock).[1]

Risk

The most common issuers of both convertible bonds and convertible preferreds are non-investment-grade-rated companies. The convertible securities may be nonrated or rated below BBB– from the major rating agencies, such as Moody's or Standard & Poor's. An interesting point to note is that most companies that issue convertibles don't default on their obligations, but credit analysis of each issuer is important because there is that risk.[2][3]

Convertible bond risks are discussed in more detail here.

Convertible preferred shares are usually issued by financial companies to bolster capital ratios for regulatory reasons. They generally are not redeemable, i.e. they have no time limit. They are significantly riskier than convertible bonds given that:[4]

  • they tend to have no time limit, so what sets the price is the general level in interest rates, and the credit risk of the particular issuer
  • they rank behind debt as priority in a liquidation or sale of the business, therefore they have higher credit risk

Accordingly the Vanguard Fund (VCVSX) below, for example, is heavily weighted towards convertible bonds which are lower risk. In both cases, it underlines the need for specialist expertise to determine if the "call" option awarded to the investor (the right to convert into common stock) is correctly valued.[4]

Convertible bonds

Main article: Convertible bonds

Convertible preferred stocks

Convertible preferred stock is a stock which carries a right to convert into common stock at a certain pre-specified exercise (or strike) price. The analysis of the value of this option (effectively a long dated call option) to the investor is complex and it is a relatively risky area that requires expertise to make successful investments.[5]

Unlike convertible bonds, convertible preferreds lack a maturity date -- unless they are redeemable and a date is specified at issue. Convertible preferreds have greater equity upside potential than straight preferreds, but normally lower starting yields and greater volatility.[2][6]

Convertible securities funds

Basically for individual investors these things make no sense for variety of reasons, including asset location and the asymmetric call risk.

And in fund you are paying high expenses for the bond side of the risk-at least the interest rate side you can get at zero cost yourself.

Institutional investors like insurance companies use them to get around capital requirement rules--they want more equity exposure but it requires more capital than bond exposure so they "cheat" by getting their equity exposure on the bond side--this leads IMO to overpricing of converts--which allowed hedge funds to arb them for long time. But then so much money came into the market to exploit it that at one point almost all trading was done by hedge funds so no one left to exploit---the trade got overcrowded.

--Larry Swedroe, forum thread I don't understand Convertible Securities

Below are two example funds which are composed primarily of convertible preferred stocks and bonds.

  • Fidelity Convertible Securities Fund (FCVSX), which tracks the Bank of America Merrill Lynch All U.S. Convertibles Index.
  • Vanguard Convertible Securities Fund (VCVSX), which tracks a Spliced Convertibles Composite Index consisting of 70% Bank of America Merrill Lynch All US Convertibles Index and 30% Bank of America Merrill Lynch Global 300 Convertibles ex-US Index (hedged)[7][note 1]
Fund Characteristics
As of 12/31/2013
Fund Characteristics Fidelity (FCVSX) Vanguard (VCVSX)
Allocation - Bonds 0.05% --
Allocation - Cash & Net Other Assets 9.85% 2.01%
Allocation - Convertible Bonds 59.41% 89.35%
Allocation - Convertible Preferred Stock 12.19% 8.64%
Allocation - Equities 18.5% --
Diversification - non-US Holdings 1.4% 21.4%
Expense ratio 0.76% 0.52%
Turnover ratio 22%* 100.6%*
*As of Fiscal Year end November 2013.
Bond Credit Quality (% of Bonds)
As of 12/31/2013
Bond Credit Quality (% of Bonds) Fidelity (FCVSX) Vanguard (VCVSX)
U.S. Government 0.00% --
AAA 0.00% 0.00%
AA 0.00% 0.30%
A 0.94% 2.20%
BBB 13.03% 5.50%
BB 13.74% 19.00%
B 19.94% 12.50%
B or Lower -- 1.50%
CCC & Below 3.00% --
Short-Term Rated 0.00% --
Not rated[note 2] 39.52% 59.00%
Equity Sector Diversification
As of 12/31/2013
Equity Sector Diversification Fidelity (FCVSX) Vanguard (VCVSX)
Consumer Discretionary 20.46% 12.60%
Consumer Staples 1.95% 1.90%
Energy 10.97% 14.10%
Financials 12.59% 10.50%
Health Care 10.90% 18.60%
Industrials 10.89% 9.50%
Information Technology 18.74% 25.90%
Materials 1.30% 4.80%
Telecommunication Services 2.33% 1.60%
Utilities 0.00% 0.50%
Other 0.00% 0.00%

Notes

  1. Spliced Convertibles Composite Index. An index that reflects performance of the CS First Boston Convertibles Index through November 30, 2004; the Bank of America Merrill Lynch All US Convertibles Index through December 31, 2010; and a composite index consisting of 70% Bank of America Merrill Lynch All US Convertibles Index and 30% Bank of America Merrill Lynch Global 300 Convertibles ex-US Index (hedged) thereafter.(Vanguard Convertible Securities Fund Prospectus Investor Shares, page 45.)
  2. Where no rating has been assigned or where a rating has been withdrawn, it may be for reasons unrelated to the creditworthiness of the issue. See: About Moody's Ratings: Ratings Definitions, from Moody's Corporation.
    Additionally, companies choose not to seek a credit rating if:
    • the buyers of the securities are specialist investors, who make their own analyses and don't rely on credit ratings
    • the company has not issued enough securities to justify the cost of a credit rating
    • the credit rating would be low enough that it would hurt the company with investors
    Therefore Not Rated while in and of itself does not signify risk (some quite respectable companies don't bother with credit ratings), it does underline the specialist nature of these environments. -- Re: Wiki - Convertible Securities, by forum member Valuethinker, direct link to post.

See also

References

  1. 1.0 1.1 1.2 Convertible Securities - Convertibles (Fast Answer), from the SEC.
  2. 2.0 2.1 What you need to know about convertible securities, from Vanguard.
  3. Can you talk me out of Preferred Stocks?, by forum member Valuethinker, direct link to post.
  4. 4.0 4.1 Re: Wiki - Convertible Securities, by forum member Valuethinker, direct link to post.
  5. Re: Can you talk me out of Preferred Stocks?, by forum member Valuethinker, direct link to post.
  6. Re: Wiki - Convertible Securities, by forum member Valuethinker, direct link to post.
  7. Vanguard Convertible Securities Fund Statutory Prospectus, from Vanguard.

External links

Forum discussions

Fund information