What it is:
Mandatory Convertibles are hybrid securities (bonds linked to equities) that automatically convert to equity (stock) at a pre-determined date. Common names are PERCS (Preferred Equity Redemption Cumulative Stock) and DECS (Debt Exchangeable for Common Stock or Dividend Enhanced Convertible Securities).
How it works (Example):
A company may wish to issue common stock but feel that the time is not right to do so, either because of general market conditions or due to the price pressure it might place on the current shares outstanding. In this case, the company may decide to issue mandatory convertibles to achieve the same goal; namely, raising capital for the company. The investor may receive a higher income from this type of bond to compensate for not receiving full appreciation potential of the stock and its dividends.
As a rule, three items characterize this type of security: 1) conversion to equity is mandatory; 2) the dividend yield is generally higher compared to the underlying stock; and 3) the appreciation is capped or limited compared to the underlying common stock.
For example, Company XYZ may issue mandatory convertibles that pay a yield of 12% and are converted to common shares one year after the issue date at a ratio of 1:1. Investors will receive a 12% income stream for the next year. After the maturity date, these investors would then own one share of common XYZ stock in place of each bond held.
Why it Matters:
Mandatory convertibles are a financing mechanism, available to corporations, that avoid some of the downside risks of pure debt or equity issues. Unlike pure debt issues, such as corporate bonds, mandatory convertibles do not pose a credit risk later for the company issuing them since they eventually convert to equity. Mandatory convertibles also alleviate some of the downward pressure a pure equity issuance would place on the underlying stock since they are not immediately converted to shares.
Investors may find mandatory convertibles attractive since they usually provide a higher yield than the underlying stock and a chance at additional gains (although usually limited) if the underlying stock appreciates in price.