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Convertible debt is a financing term that is used to refer to any type of debt financing where there is the option of converting the outstanding balance due to some other form of security or asset. The term is used in reference to mortgages and other types of debt, as well as with various forms of securities.
As it relates to a mortgage, convertible debt would be any type of arrangement that allowed the conversion of the outstanding balance owed into equity. This factor can come in very handy in the event that the borrower defaults on the repayment terms associated with the mortgage. The mortgage holder can choose to convert the debt into equity and thus be in a position to recover from the loss created by the default.
In terms of other types of securities, such as a corporate security, convertible debt is sometimes used to refer to the ability to exchange one type of security issued by the corporation for a different type of security. For example, an outstanding bond issue that has terms and conditions that allow the bond to be converted into shares of common stock would be considered an example of convertible debt. While this option does not necessarily have to be exercised, the terms usually define how the conversion would take place and at what price each share of stock would be issued.
Convertible debt is sometimes referred to as one of the several hybrid investment models in common use today. This option is often a mechanism that provides the holder of the debt with some added security, and options on how to proceed in the event that the debt is endangered in some manner, such as in a default situation. The decision to structure a security as convertible can be made for a number of reasons, including projections for some future event that would make the conversion more advantageous for all parties involved. However, any investor should be advised to consider the terms and conditions associated with the specific transaction before entering into any agreement involving convertible debt.
Investing in convertible debt in which the conversion option kicks in when the company is in danger of default is risky.
If a company can't pay on its original debt, there is a good chance it will not be able to pay dividends on equity upon conversion.
In addition, if a defaulted company cannot restructure or refinance its debt, it may be forced to file bankruptcy.
Existing equity holders rarely recover anything in a bankruptcy case.
As a result, if you are dealing with a company that includes a default conversion clause, it may be wiser to buy high-yield or other bond offerings from that company to better ensure a chance of recovery in the event of financial disaster.