Forced Conversion

What Is a Forced Conversion?

Forced conversion happens when the issuer of a convertible security exercises their right to call the issue. In doing as such, the issuer forces the holders of the convertible security to change over their securities into a foreordained number of shares.

Regularly, issuers decide to start a forced conversion when interest rates have declined fundamentally since their convertible security was issued. In such a scenario, the forced conversion benefits the security issuer since it permits them to reduce their interest burden and possibly issue new debt securities at a lower interest rate.

How Forced Conversions Work

Forced conversions are one of the risks looked by purchasers of convertible securities, which are a type of debt instrument that can be changed over into shares of underlying stock.

For instance, a convertible bond could give the investor the right to exchange their debt instrument for a certain number of shares in the company giving the bond. Contingent upon how the price of the shares changes after some time, the bondholder might feel that they are much improved off practicing their conversion privilege and turning into a common shareholder.

Now and again, convertible securities are likewise callable, implying that they give the issuer the right to force the security holder to change over their holdings. On account of convertible bonds, this would provoke a forced conversion of the bonds into a foreordained number of common shares. Since forced conversions are initiated at the caution of the security issuer, they are generally not positive for investors. Hence, securities that can be called by the issuer generally trade at a discount relative to comparable securities that don't have this provision.

The Conversion Ratio

While choosing to purchase a convertible security, the investor will consider the security's conversion ratio. The conversion ratio indicates the number of shares of the responsible that company the investor would receive in the event that a forced conversion is set off.

For example, a convertible bond with a 10-to-1 conversion ratio would permit the bondholder to exchange each $1,000 of par value into 10 shares of stock. Assuming the stock price rises after the bond has been purchased, this would make it more enticing for the bondholder to exercise this option.

In like manner, it could likewise support the convertible bond issuer to call the bond, triggering a forced conversion.

Illustration of a Forced Conversion

Michaela is a retail investor with a portfolio of convertible bonds. Her biggest single position is in the convertible bonds of XYZ Enterprises, which she purchased with a conversion ratio of 25-to-1. Michaela has invested $100,000 into XYZ's convertible bonds, and the company's shares were trading for $40 at the time that she purchased them.

As of late, Michaela received notice from XYZ that they had chosen for call her convertible bonds, triggering a forced conversion of her debt into equity. Since the bonds offered a conversion ratio of 25 shares for each $1,000 of par value, this means that Michaela was forced to exchange her $100,000 of XYZ bonds for 2,500 shares of XYZ common stock. At the hour of the forced conversion, XYZ's shares were all the while trading at $40, implying that the value of Michaela's common shares was still $100,000, equivalent to before the conversion.

Michaela contemplated that XYZ presumably chose to force the conversion since interest rates had declined fundamentally since the convertible bonds were issued. By driving the conversion, XYZ surrendered their existing debt, liberating themselves to borrow new funds at lower interest rates. Michaela, in the interim, has the option to either keep her common shares or, in all likelihood sell them and invest the proceeds somewhere else.

Benefits and Disadvantages of Callable Convertible Bonds

A callable bond is a debt instrument issued by a company that has a embedded option permitting the issuer to "call back" or recover those bonds before they mature. Since this option has likely value for the issuer and represents a possible risk for investors, callable bonds frequently have higher yields than equivalent bonds that are not callable.

The fundamental risk for investors is reinvestment risk. This is on the grounds that an issuer will generally exercise the call option provided that they accept they can issue new bonds and borrow at a better (i.e., lower) interest rate. Bondholders, be that as it may, who have their bonds called will be forced to consider new bonds with lower yields. Thusly, a callable bond investor might acknowledge this risk in return for a higher yield particularly in the event that they accept that interest rates will hold consistent or rise over the bond's maturity.

Note that with a callable convertible bond that is likewise callable, there are two embedded options. One is great for the investor: they can change over their debt into common stock at a certain price and amount. In this way, assuming the stock rises, it benefits the bondholder.

Pros and Cons of Callable Convertibles (from the perspective of bondholder investors)

Pros

Option to convert the bond into stock
The call feature of the issuer increases the yield over other convertibles

Cons

The call option can be used by the issuer if rates fall causing reinvestment risk
If called, there could be an unwanted forced conversion

## Features - They will then, at that point, have reinvestment risk as new securities will more often than not offer lower yields than the called securities. - Forced conversion is the practice of changing over debt into equity at the demand of a security issuer. - Since forced conversions are a risk to investors, callable securities will quite often offer somewhat higher yields compared to comparative non-callable alternatives. - Investors run the risk of being subject to forced conversions when they purchase callable convertible securities. - An issuer might demand conversion or call in callable securities in response to falling interest rates, really permitting the issuer to refinance debts. ## FAQ ### What Is the Difference Between a Convertible Bond and a Callable Bond? A convertible bond is one that can be changed into the issuer's common stock. A callable bond is one that can be recovered right on time by the issuer. The former is an option that inclines toward the investor, while the last option has expected value for the issuer. A few bonds are issued as both callable and convertible, which can bring about a forced conversion for the investor of the bonds into shares when they are called in. ### What Is a Mandatory Convertible Bond? A [mandatory convertible bond](/mandatoryconvertible) has a requirement that the bond be changed over into shares by the investor, instead of having the option to do as such. Since the issuer's stock might be higher or lower than when the bonds were issued, there is a risk to the bondholder, bringing about higher yields than a normal convertible. ### Why Are Convertible Bonds Attractive to Investors? Investors might find convertible bonds appealing in light of the fact that, as debt instruments, they are more secure than a bond and will quite often pay normal interest payments. They can likewise be changed over into the issuer's stock, which can give a windfall to investors in the event that the price of the stock rises substantially before the bond matures. ### Are Treasury Bonds and Notes Callable? No. As a general rule, Treasuries are not callable by the government.