What is a Mandatory Convertible Bond?

What is a mandatory convertible?

A mandatory convertible is an instrument that turns into equity at maturity – whether the shares have traded up or down. This clearly has a very different structure to a convertible - which behaves like a bond on the downside and like equity on the upside. A typical mandatory has a 3-year maturity. It delivers 1 share if the share price at maturity is at or below the share price when launched – so effectively, exactly like owning equity for investors. If the share price is higher though, the instrument is settled with fewer shares until a limit (or premium) is reached, for example, 20-25% above the original share price, above which investors again receive a fixed number of shares.

If the premium is set at 25%, then above this level investors will receive 0.8 shares. At or below the original share price investors receive 1 share. Between the original price and the 25% premium they receive a reduced number of shares from 1 to 0.8. As a result, on the upside, investors get a return that is worse than holding straight equity. To compensate for this loss, mandatories have a coupon that is well above the dividend yield.

Why would an issuer sell mandatory convertibles instead of equity?

Mandatories were introduced as a way of selling equity initially for companies with low dividend yields to equity income funds. For example, if an income fund has to buy companies with dividend yields over 3%, then it will not have exposure to some sectors. However, by issuing a mandatory with the higher yield, they can buy exposure to these companies’ shares. Over time the market has expanded, with many hedge funds also buying the product.  

For issuers this is an instrument much closer to equity – it is generally not treated as debt. Also, it signals that the company is confident the share price will rise. They are sometimes done in conjunction with straight equity – which will hopefully increase the demand for what is effectively more equity, by creating additional demand from different equity-income funds and equity-linked investors.

What is an example of a mandatory convertible?

A good example of a mandatory is the €4bn issue from Bayer in late 2016, as part of its financing of its $66bn acquisition of Monsanto. The mandatory was an early part of the refinancing of the bank debt that had been put in place for the acquisition. When launched, investors also knew that a large rights issue (ultimately €6bn) would follow, as well as many other debt instruments and disposals. The instrument had a 3-year maturity and was launched with a 5.125% to 5.625% coupon range and 20% to 25% premium range. The issue was priced at the ‘best’ end for investors with a 5.625% coupon and 20% premium, although this was not unexpected as it was Europe’s largest-ever mandatory convertible.