Today, I’ll conclude the post I started last week on convertible debt as it relates to the common stock investor’s position. You may want to revisit last week’s post for context.

Simply stated, the convertible debt holder is a lender to a company where the underlying loan incorporates an equity option.

There are probably few decisions made by a company’s management that change an existing stockholder’s position more than one where the company issues convertible debt. “Stock buyer, beware” is a fitting commentary.

As described last time, the convertible debt holder, through the equity option incorporated with the debt, has more rights than the straight debt holder. The stronger relative position of the convertible debt holder corresponds with a weaker position now held by the stockholder.

What does the convertible’s equity option mean? It means that if conversion of the debt to equity (stock) takes place, future earnings per share will be diluted (watered down) as earnings would be spread over an increased number of stock shares outstanding. This alone causes the conversion price (described in my last post) to often function as a lid on how high the stock price can progress. That’s because dilution is avoided by the conversion NOT happening.

A stock price rising above the conversion price would increase the likelihood of conversion. So, if the conversion price is $20 a share, for example, the stock price may indeed struggle, after the convertible debt deal is closed, to get to that $20 level or higher (and remain there) due to the threat that dilution poses, should conversion happen.

There’s more to it too. A convertible debt holder (or lender) knows that the conversion price forms a lid of sorts on how high the stock price may rise so long as the convertible debt exists. So the convertible lender often short-sells the company stock at the time that the convertible deal is transacted. (Go here to read about shorting a stock).

Also, by shorting the underlying company stock, the convertible lender virtually does away with risk, including the risk of a company default in repaying the debt. Let’s consider three hypothetical scenarios below.

Scenario 1: The company does not default and conversion does not occur prior to the debt maturing; in this scenario, the convertible debt holder collects interest across the life of the loan and receives a return of principal. If the stock price has fallen below the shorted price (probable since conversion never occurred across the life of the loan), there would also be money made on the short position upon covering it.

Scenario 2: The company defaults before the convertible debt matures; here, the convertible holder collects interest payments until the default occurs and then will bank the profit from the price where the stock was shorted all the way down to zero since a stock price will almost always go to zero on a company default. This profit derived from shorting the stock would virtually offset the loss of debt principal not repaid due to company default.

Scenario 3: The  stock price goes up above the conversion price and conversion occurs; here, the convertible debt holder simply takes the stock shares attained from conversion of the debt to equity (in lieu of cash repayment) and uses those shares to cover the shorted position. So, there’s no risk of loss from having shorted the stock at prices much lower than where the stock price might eventually advance. Also, until the conversion, the convertible lender will collect interest.

In sum, by shorting enough shares around the time of the convertible debt offering to approximately equal the debt principal amount, the convertible debt holder is protected against a rising stock price or a falling stock price, and most importantly, from a company default.  A straight debt holder cannot devise a risk-free hedge for virtually any possible scenario, but a convertible debt holder can.

This is technical stuff, I know. The important thing to know is that convertible debt does not favor the stockholder’s position, but empowers the debt holder at the stockholder’s expense. I’m not saying that it always works out badly for the stockholders. And it may be the only viable option for a company seeking capital. However, it clearly is not as attractive, for stockholders, as a straight debt deal where the lender gets no “additional” rights beyond what a lender would experience where the company is negotiating from a position of strength.

Convertible debt is usually offered by companies where the balance sheets and earnings outlooks reflect a lack of negotiating strength. The conversion price that results from the convertible debt offering will likely act as a lid on the stock price until the company is able to render strong enough operating results to overcome the convertible’s position of power.