Hybrid Conversion Mechanics

When your client asks - 'what happens to my hybrid at conversion?' confidence in hybrid conversion mechanics will stand you in good stead to answer this question.

Hybrid securities have been popular for many years with investors and issuers.  They can provide franked dividends and the chance to gain equity exposure when the security undergoes the conversion process. 

With Conversion there are four key variables to be aware of. 
 1. The note may have a mandatory conversion into shares or cash
 2. There may be choice on the part of the issuer or holder regarding the date of conversion, i.e. the note may become perpetual in nature
 3. Upon conversion if there may be a fixed conversion ratio; or
 4. At conversion there may be a dollar value conversion ratio.

Some of the features that are found in a note with a fixed conversion ratio include:

· A set rate of return (coupon rate) until conversion
· Issued at a similar price to the underlying share
· Convert into a set ratio e.g. 1 hybrid converts into 1 underlying share.

This structure means the value of the convertible preference share is closely linked to the ordinary share price.
This is illustrated by the graph below,

BPC vs CPCPA graph
This point is important, as the conversion processes will have a direct bearing on the capital profile of the security.  For clients looking for a capital stability, an alternate conversion style, the dollar value conversion, may be a consideration.


In the case of a dollar value conversion style holders are entitled to a certain dollar value amount of shares following conversion.  The effect of a dollar value conversion structure means a more capital stable profile as demonstrated by the graph below.
Which is more stable - CBA or CBAPA graph
In the case of a dollar value conversion the ordinary share price level has less impact on the hybrid.  The variable is the number of ordinary shares to be issued, reflecting the defined dollar value. 

However, equity upside and downside exposure is added with a secondary feature - constraints on the number of shares to be issued.  Namely a minimum and maximum numbers of shares, this is explained in greater detail in the case study below.

Reset preference share
Another feature, which can be added to the mix, is the ability for the issuer to offer new terms at a predetermined date, the 'Reset date'.  For the issuer this gives flexibility of not having a mandatory conversion.  Instead, new terms or an extension of the terms can be offered.  Holders can accept the new terms or choose to decline and exit via a predefined conversion exchange mechanism.  The flow chart below gives a simple guide to the general patterns that can be followed by reset preference shares.
Reset preference share reset/conversion/repayment flow chart
Equity Exposure
Looking at the equity exposure that occurs with a hybrid, this occurs by setting a minimum and a maximum number of shares that can be received per hybrid. 

In the case of a conversion with a pre-set minimum number of shares; if the calculation of the number of shares to be delivered falls below the minimum, the pre-set minimum number is returned regardless. 

This is the feature that determines the equity upside.  The higher the share price at conversion the lower the number of shares that the dollar value conversion will result in.  Therefore the higher the pre-set minimum, the greater the final dollar value that can be achieved.

In creating downside exposure a hybrid will have a conversion maximum.  The lower the share price at conversion, the greater the number of shares that the dollar value conversion amount would result in.  Consequently the maximum conversion caps the number of shares that that a hybrid holder is entitled to on conversion.  Hence the lower the pre-set maximum number of shares the greater the downside equity exposure.


Case Study
A recent Timbercorp (ASX code: TIM) issue of a reset preference share provides an example of the conversion process. 

When looking at the conversion terms, the first thing to investigate is when a conversion can occur.  With the Timbercorp RPS, conversion can occur at the first reset date, September 2009.  Conversion at any point earlier than this can occur in the event of certain 'Trigger' events.  Also early holder conversion can occur with certain constraints.  Trigger events include takeover bids, changes in tax or accounting treatment of RPS, or preset financial boundaries such as a maintaining a minimum market capitalisation on issue.

The conversion outcome is then the next item to investigate.  In the Timbercorp case, conversion into shares is not assured, Timbercorp has structured the issue to allow them the discretion of converting into cash as well.

Looking at the conversion ratio (which is the calculation that determines the equity exposure of the RPS), this is defined as 'Face value divided by the VWAP for the 20 business days prior to exchange less the conversion discount of 2.5% subject to a minimum of shares of 0.9091, and a maximum number of shares of 4.00.'  This calculation means that investors will benefit in any upside in the TIM share price above $2.26 and have equity downside below $0.51.

So how is this worked out?  The table below aims to provide a guide to the conversion calculations.

TIM RPS Face Value TIM 20 day VWAP Discounted VWAP price How many shares would the hybrid convert into? Number of shares allotted on conversion under terms in prospectus Value of holding after conversion at market price

A

B

C = B - 2.5%

D = A/C

E

G = E*B

$2

$0.20

$0.195

10.2

4

$0.8

$2

$0.51

$0.49725

4.02

4

$2.04

$2

$1.00

$0.975

2.05

2.05

$2.05

$2

$1.50

$1.4625

1.37

1.37

$2.05

$2

$2.26

$2.2035

0.9

0.9091

$2.05

$2

$2.50

$2.4375

0.8

0.9091

$2.27


When investigating the conversion process for a particular security knowing where to find the relevant information makes the process much simpler.  All interest rate securities (IRS) are unique so you will need to refer to the prospectus to find their exact details.  These can be sourced via the ASX company announcements page.

For those securities that no longer have their prospectus in a pdf version on the ASX website, they can be purchased through ASX Customer Service, 131 279.  There is a printing and administrative fee for this service.  Most IRS will have a summary prospectus that can be located at www.asx.com.au/irm.htm

Any queries please fell free to contact the IRS department of ASX, irm@asx.com.au