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Hybrid Securities Part 2 – Convertible notes
Many thanks to Dean Greacen from SMSF Investor for today’s post. Dean will be sharing with us a series of posts on Hybrid Securities, which could be a great investment for SMSFs seeking high yield with capital growth.
Convertible Notes are debt instruments that may be converted to an equity holding at a future date. A convertible note is therefore issued with a right to convert the holding into an agreed number of ordinary shares at inception, or at a time closer to conversion. In effect, a convertible note is a fixed interest security with a call option to purchase shares at some later date.
Prior to conversion, the convertible note is debt-like with investors receiving interest payments. At this stage the instrument generally does not convey the same benefits as equity, however, like a debenture, investors would receive their normal fixed interest payments for the duration of their ownership of the note.
Commonly there is a conversion formula which provides for a ’floor‘, thus guaranteeing the holder will get equity of at least the value of their investment. However, should the share price fall to a level substantially lower than the issue and conversion price, the holder is still guaranteed cash on maturity of the note.
Convertible notes are particularly advantageous to the investor if the market value of the company’s shares increases over the period they hold the note.
If the attached right is exercised, the note is cancelled and the note holder is issued with the agreed number of shares. Interest payments will accordingly cease and the (now) shareholders become entitled to any dividends declared on the shares. They will also be able to vote at shareholders’ meetings in accordance with the voting rights attached to the shares.
An advantage for a company in issuing convertible notes is that they will be able to avoid having to raise further funds to redeem the notes if investors convert their holdings into shares. It should be remembered, however, that the issuing of shares will dilute the value of the existing share capital of the company.
A number of other advantages accrue to a company issuing convertible notes. Often these securities have terms of up to ten years which provides the issuing company with fixed-rate long-term debt finance. Convertible notes therefore represent the only way that some newer and smaller companies have of obtaining long term fixed interest finance. Being a long-term security, convertible notes are attractive to institutions with long-term liabilities, such as superannuation funds.
Convertible notes are also attractive to an issuing company in their own right, as they are an unsecured liability. A company that has pledged its existing assets as security for other loans can issue convertible notes. The unsecured nature of these debt like securities does, however, represent a risk to note holders.
Some markets will purchase a note that converts into a share in preference to purchasing an ordinary share. Large companies often feel more secure knowing that their capital is spread amongst a number of different markets rather than being dependent on one market only for their capital. Convertible notes offer the opportunity to access these other capital markets.
In certain circumstances convertible note issues are released undated, giving an extended period in which to convert them into equity, thus creating a form of perpetual debt. Alternatively, convertible instruments can be callable, meaning the issuing company has the right to repurchase the instrument at a certain price in the future, thereby forcing holders of the debt instrument to convert to equity sooner than they may otherwise have chosen.
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SMSF Investor is a company that provides expert help to SMSFs. They offer SMSF clients a range of products and services tailored specifically to meet their needs as self managed super fund investors such as a SMSF Investor course and investment advice if needed.
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