Percs and decs
Mandatory convertible instruments give equity investors increased income in exchange for reduced upside participation. These “convertibles” mandatorily convert into ordinary shares at maturity. Thus, there is only limited optionality for the investor.
The key difference between a mandatory and a traditional convertible is that, as shares are always issued, the investor cannot receive cash on redemption. There are two basic structures, with variations on these structures sometimes altering their characteristics. Preferred equity redeemable cumulative stock (Percs) are preferred shares that automatically convert into one ordinary stock upon maturity. They are usually issued at the prevailing share price, convertible into one ordinary share, with an enhanced dividend yield. The “redemption” in the acronym refers to the fact that these preference shares have a finite life, and the only cash that investors receive is the dividend payments. Percs pay a higher dividend than common shares, but the equity upside is capped. Above a certain share price, the conversion ratio will fall as the stock rises, capping the upside at that level. Below this level, the conversion ratio remains one-for-one, giving the same downside exposure as the ordinary shares, excluding the income difference. In terms of valuation, the Percs structure is very simple. In buying a Perc at issue, an investor is essentially buying the shares – less any dividends over the life of the instrument – and selling a call option struck at the price of the cap. Generally, the investor cannot convert Percs ahead of maturity. However, most Percs are callable at any time by the issuer. The call price declines over time, generally to the level of the share price cap. Investors also receive the value of unpaid and accrued interest. Dividend enhanced convertible stock (Decs) are generally either preference shares or subordinated bonds. These, like Percs, mandatorily convert into ordinary shares at maturity, if not already converted. Decs give no significant downside protection and are very equity sensitive with minimal direct bond characteristics and interest rate exposure. As with Percs, some of the upside performance is given away and in return, the investor receives an enhanced yield over the ordinary shares. Unlike Percs, however, the investor’s upside is not capped. Instead, the investor trades a zone of flat exposure to the share price for the enhanced income. Decs are generally issued at the same price as the underlying shares, but the conversion ratio depends upon the prevailing stock price at maturity. If the share price is at the issue price or below, the conversion ratio will be 1:1, giving the investor all the downside of the shares, though with a significantly enhanced yield, and therefore a far higher total return. Between the issue price and a set higher level – generally a premium of 20 to 25 per cent – the conversion price will rise with the share price so that the investor has neither capital gain nor loss. Above this level, the investor will regain upside exposure at the lowest conversion ratio. With Decs, investors can convert at any time, but only at the lower minimum conversion ratio. There is an early redemption feature, with calls common in the final year of the typical four-year structure. The call is generally at a small premium to the issue price plus accrued interest, but is payable in stock – the number of shares that the investor receives will not fall below the minimum.
