Warrants and Convertibles are a type of derivative investment securities. Both these types of options give investors a right to further invest in certain securities of the company. Specifically, a warrant gives investors a right to buy an underlying security at a certain rate in the future. Convertibles, on the other hand, allow investors to convert their security into the common stock in the future. Thus, both these securities help investors to maximize their returns and are the available investment options. But both these are not the same, hence it is important how these two instruments should be used and the purpose thereof. Therefore, investors should know and appreciate the difference between warrants and convertibles.
Before we detail the difference between warrants and convertibles, it is important that investors understand what the two terms mean.
Warrants and Convertibles – Meaning
It gives investors a right to buy the underlying share, bond or any other security at a certain future date and at a specific price. However, there is no obligation for investors to buy the underlying security at that time and at that price. Moreover, if an investor decides to exercise the warrant, then he or she needs to pay the pre-decided money to buy the stock or security or the instrument. Many features of a warrant are the same as that of options.
Every warrant carries the information on the number of underlying security an investor can buy and at what price and at what date. The time period of a warrant varies and could be of several years. Investors can trade warrants as well, and their value depends on two things – time and intrinsic value. The value of a warrant will be more if the time left until expiration is more. Similar will be the situation of the warrant value if the market price of the underlying security is more than its exercise price.
Convertibles, on the other hand, give investors an option to convert bonds or preferred stocks into common stock in the future again at a specified date and price. Usually, companies that want to raise quick capital or do not have access to traditional financing options, use this type of security. A company uses a conversion ratio to determine the number of common shares that an investor would get in place of the bond or preference shares. Further, the instrument can be fully convertible, the entire bond will get converted and the existing security will stand discharged. Or it can be partially convertible, thereby a portion will get converted to common stock and the leftover value will continue to remain as bond, the total value of the bond stand reduced to the extent of conversion.
Difference Between Warrants and Convertibles
Following are the differences between warrants and convertibles:
Warrants come with an expiry date, and thus, many view them as a short-term investment. Convertibles, on the other hand, have a longer duration, and thus, are long-term options.
When an investor exercises a warrant, he or she needs to give more money to acquire the shares. Hence, in this situation, the company gets additional money from the instrument holder. Whereas, in the case of convertibles, there is no additional cash outflow from investors’ perspectives. The same security converts to common stock using the conversion ratio.
The price at which an investor will be able to buy the underlying security in the future is detailed in the warrants at the time of issuance itself. And this price remains fixed until the expiry. However, there is no such fixed price in the case of convertibles. Rather, the issuer uses a conversion ratio to determine the number of common shares that an investor would get on converting the bond or preference shares.
Warrants have a very unique characteristic. They are detachable, which means one can trade them separately from the underlying security. Convertibles, however, are not detachable and thus, investors can not trade them separately.
In the case of warrants, whether or not the investor exercises the warrant, the underlying security remains on the company’s books of accounts. However, if an investor uses convertibles and converts the bonds or preference shares, then the bonds or preference shares is removed from the company’s books of accounts.
When we talk about ownership, a warrant does not give the investor ownership of the underlying security. The owneship starts only after the investor uses the warrant to buy the underlying security. Convertibles, on the other hand, give investors ownership of the security from the very beginning.
Warrant will become worthless for exercise if the market price of the underlying security drops below the exercise price. Convertibles, on the other hand, become worthless only and only if the company goes bankrupt. Even if the share price of the issuer drops, the investor will not exercise the option and would still have the ownership of the bond or preference shares.
Warrants do not have any intrinsic value of their own, and depend on the value of the underlying asset. Convertibles, however, have their own intrinsic value even, both before and after use of the option.
Both warrants and convertibles can have an important place in a company’s capital structure. These are also equally important in the investor portfolio. Warrants and convertibles, both have some common features. However, they are very different and hence their market price also fluctuate not exactly in the same proportion. And, this is what makes them appeal to different sets of investors. Generally, more risk-averse investors prefer warrants, while those who prefer some security go for convertibles.
Frequently Asked Questions (FAQs)
A warrant gives investors a right to buy an underlying security at a certain rate in the future. While a convertible allows investors to convert their security into the common stock in the future.
Some of the points of difference between warrants and convertibles include time frame, cash outflow, fixed price, detachability, accounting, ownership, etc.
Warrants become worthless if the market price of the underlying security drops below the exercise price. Convertibles become worthless only if the company goes bankrupt.