A mandatory convertible bond has a specific conversion date and offers higher yields than other types of convertible bonds, but changes in market conditions may decrease the value of the underlying shares. Investors must project the likely level of return on the stock.
A mandatory convertible is a bond issue that includes a mandatory or mandatory redemption or conversion feature within the terms associated with the sale of the bond. Unlike other types of convertible bonds, the investor does not have the ability to select among various options as the conversion date approaches. Instead, there is a specific course of action that will begin on the date assigned in the terms of the bond, or at an earlier time if the bond is set to allow the issuer to call the bond early.
One of the most common structures for a mandatory convertible is to set the terms by which the investor must convert the bond into the common stock underlying the bond. Until that time, the investor earns a fixed or variable interest rate on the bond issue. When the maturity date arrives, the final interest payment is calculated, then the remainder of the bond’s value is converted into the appropriate number of shares and issued to the investor.
There are two benefits associated with acquiring a mandatory convertible. First, the terms of the bond issue are very simple. 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 really a good long-term investment.
Another important benefit to investors is that the typical mandatory convertible is structured to provide higher yields than other types of convertible bonds can produce. This provides an additional incentive for investors to opt into the bond issue that offers nothing in the way of options and only allows for final resolution. Assuming the unit value of the shares ultimately issued to the investor posts a good price and shows signs of appreciation, that return can be quite substantial.
While there are benefits to investing in a mandatory convertible, there are also drawbacks to consider. Changes in market conditions may decrease the value of those underlying shares over the life of the bond. This means that at the time of conversion, the investor will get less return. If the market trends continue in the same vein, there is a chance that the investor will ultimately lose money on the deal. For this reason, investors must not only keep a close eye on the rate of return earned up to the point of maturity of the bond, but also project the likely level of return on the underlying stock at and beyond that maturity date.
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