What is a Mandatory Convertible?
A mandatory convertible is a bond issue that includes a required or mandatory redemption or conversion feature within the terms related to the sale of the bond. Unlike some other types of convertible bonds, the investor does not have the ability to select from several options when the date of conversion approaches. Instead, there is one specific course of action that will commence on the date assigned in the bond terms, or at an earlier point in time if the bond is configured to allow the issuer to call the bond early.
One of the more common structures for a mandatory convertible is to set the terms so that the investor must convert the bond into the common stock that underlies the bond. Up to that point, the investor earns a fixed or variable rate of interest on the bond issue. When the maturity date arrives, the final interest payment is calculated, then the remainder of the bond’s worth is converted into the appropriate number of shares, and issued to the investor.
There are two benefits associated with the acquisition of a mandatory convertible. First, the terms of the bond issue are very straightforward. Investors know exactly what to expect and when the conversion is likely to take place. This makes it much easier to project the rate of return, and determine if the bond is actually a sound investment in the long run.
Another important benefit for investors is that the typical mandatory convertible is structured to provide higher yields than other types of convertible bonds are likely to produce. This provides an added incentive for investors to go with the bond issue that offers nothing in the way of options, and allows only one final resolution. Assuming that the per unit value of the shares ultimately issued to the investor post at a good price and show signs of appreciating, that yield can be quite substantial.
While there are benefits to investing in a mandatory convertible, there are also drawbacks to consider. Changes in market conditions can decrease the value of those underlying shares during the life of the bond. This means that at the point of conversion, the investor will realize less of a return. Should market trends continue along the same lines, there is the chance that the investor could ultimately lose money on the deal. For this reason, investors should not only look closely at the rate of return earned up to the point of the bond’s maturation, but also project the likely level of performance of the underlying stock at and beyond that date of maturity.
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