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A forced conversion is a situation in which the issuer of a given security chooses to exercise his or her right to initiate a call on that security. When this occurs, investors have no choice but to accept the call and begin the process of converting the security according to the terms and conditions related to the original investment. It is important to note that the issuer can only initiate a forced conversion by complying with the call provision that is provided to the buyer at the time the security is purchased. This often means that specific events must occur, or a certain amount of time must pass, before the security can be called.
There are several reasons why an issuer may choose to initiate a forced conversion. One of the most common has to do with changes in the value of the underlying assets that support the security. Should the value of that asset increase to the point that it is above the conversion price associated with the security, there is a good chance that the issuer will initiate the call. In like manner, if the interest rates associated with the security should fall below a certain level, the issuer is likely to call the investment.
For the most part, a forced conversion is designed to benefit the issuer, not the investor holding the security. While the investor is likely to at least recoup the initial investment, the amount of profit made on the venture is typically less than if the investment were allowed to reach full maturity. For example, with a convertible bond issue, the structure may require that once maturity is reached, the bondholder accept shares of stock that are worth considerably more than the initial investment. If the issuer calls the bond early, the return will probably be the initial investment plus some amount of interest that amounts to less than the worth of those shares of stock.
Investors should take the time to look closely at the forced conversion terms related to any convertible security, whether that security is convertible preferred stock, convertible bonds, or some type of convertible debenture. Along with considering the return realized at maturity, it is also important to determine what that return would be if the issuer exercised his or her right to call the security early. Doing so makes it easier to decide if the convertible security is worth the money and effort, or if some other type of investment would be in the best interest of the investor.
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