Hung Convertibles

  

Categories: Derivatives, Bonds

Joke construction kit, supplies: (1) the term “hung convertibles;” (2) a men’s locker room; (3) a reference to (a) a honeymoon/romantic weekend, (b) a large male ungulate, or (c) both.

Hung convertibles is a slang term for convertible securities that find themselves underwater. As such, first we'll have to define "convertible securities."

Convertible securities are financial instruments that can get turned into stock under certain conditions. Convertible bonds offer the most famous version. They act like bonds (having a maturity date, paying interest etc.), but the holder can turn them in for a certain number of shares when the situation is right.

These convertibles provide a price basis for their equivalent shares. You have a 10-year convertible bond paying 5% interest, convertible to 1,000 shares of common stock at $20 a share. A hung convertible occurs when the market price for the stock trades well below the convertible price. You have that bond convertible at $20 a share. Current price: $9...hung convertible. You wouldn't want to do the conversion, because the stock is well below the convertible price. You'd rather wait, hoping the stock will rise to above $20. Then you can sell your shares into the market and make a profit.

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finance a la shmoop. what is convertible debt? okay so we presume you

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know what debt is. if not go uh you know watch that video. we'll wait actually no [man smiles at camera]

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we won't wait. so convertible debt is just normal debt

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but with one potentially highly valuable added feature. its convertible into

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something else. well we were Marvel superheroes that would be our superpower.

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you know finance man or something like that.

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anyway example time. drone Ranger Inc needs money to upgrade a factory so that

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it can produce drones that don't just fly, they swim too. like Aquaman. Alright well

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prevailing interest rates for its level of risk and credit worthiness are 7%. the

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company needs to raise a hundred million bucks, and the idea of paying seven [graph shown]

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million dollars a year for that debt is just too high a price, so the CEO boss

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says no .no new factory for you but if the company could get the debt cheaper

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well then she might run bulk. unfortunately the company's stock trades

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today at a very low multiple of earnings. only 15 times the dollar share they'll

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earn this year. so I don't want to raise the hundred million dollars by selling

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equity. it would be dilutive to do so, meaning that they would have to print

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too many shares to raise that hundred million dollars, specifically a hundred [Dilution defined]

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million divided by 15 or six and a half-ish million shares. well some of the

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company's investors or rather all of them believe that the company's stock is

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and or will be worth more per share than it is today at some point in the future.

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otherwise they wouldn't own the stock today, right?

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so the wily CFO of the company wonders if there's a Miley Cyrus style best of

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both worlds solution here where you could sell equity at a higher price in

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the future in part for a price decline on the cost of renting the debt. and in [Cyrus shown swinging across screen]

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fact there is and yeah you guessed that it's called a convertible bond, or

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convertible debt. yeah different kind of conversion there.

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all right well the drone rangers stock is 15 bucks a share today but through

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careful negotiated back-and-forth with capital markets people at an investment

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bank, the company learns that there actually is demand for its debt price to

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pay only 3% interest. if that debt is convertible into equity at 30 bucks a

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share. so what does that mean? well if the stock stays under 30 bucks so pretty [definitions on screen]

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much forever, then the buyers of the debt or the lenders of the money to the

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company got taken. that is they only got three percent interest on their money

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when they should have gotten seven percent for loaning money as debt to the

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company. but if the stock takes off and the over water underwater drones really

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you know fly off the shelves, then the convertibility feature of the

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debt will be exercised or used which would be a good thing. so the debt is

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convertible at 30 bucks a share which means that a hundred million dollars

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raised would cause the company to be diluted a hundred billion divided by 30

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bucks, or you know 3.3 ish million shares, I eat it's half the dilution it would [equations]

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have been at the company just sold shares at 15 bucks each.

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it essentially wrote a call option to the buyers of the debt to be able to

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call or buy its stock for 30 bucks a share or 30 times the current year's

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earnings at some point you know whenever in the future. like being diluted at 30

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times earnings is way less painful than being diluted at 15 times.

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so yeah that's convertible debt in a nutshell. not what you find yourself in

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during your midlife crisis when you desperately feel the urge to buy a [woman races by in sports car]

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nice Beamer

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