Question

Name and describe two types of convertible securities

Answer 1

What is a Convertible Security

A convertible security is an investment that can be changed into another form. The most common convertible securities are convertible bonds or convertible preferred stock, which can be changed into equity or common stock. A convertible security pays a periodic fixed amount as a coupon payment (in the case of convertible bonds) or a preferred dividend (in the case of convertible preferred shares), and it specifies the price at which it can be converted into common stock.

1 CONVERTIBLE BONDS

A convertible bond is a type of debt security that can be converted into a predetermined amount of the underlying company's equity at certain times during the bond's life, usually at the discretion of the bondholder. Convertible bonds are a flexible financing option for companies and are particularly useful for companies with high risk/reward profiles. Convertible bonds are sometimes referred to as "CVs."

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Convertible Bonds

BREAKING DOWN Convertible Bond

Convertible bonds are issued by companies for a number of reasons. Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders are likely to convert to equity anyway should the company continue to do well.

Another reason for issuing convertible bonds is that investors demand a security that optimally protests their principal on the downside but allows them to participate in the upside should the underlying company succeed. A startup or relatively new company, for example, may have a risky project that loses a great deal of money on one end but may lead the company to profitability and outsize growth. A convertible bond investor can get back some principal upon failure of the company but can benefit from capital appreciation by converting the bonds into equity if the company is successful. Convertible bonds are a useful financing option for both investors and companies when the company's success resembles a binary outcome.

Convertible bonds also allow the companies issuing them to lower their borrowing costs. From the investor's perspective, a convertible bond has a value-added component built into it; it is essentially a bond with a stock option, particularly a call option, attached to it. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock. Otherwise, the bond just pays interest to the investor for his capital investment.

Example of a Convertible Bond

A company issues a $1,000 face value convertible bond paying 4% interest with a convertible ratio of 100 shares of the company for every convertible bond and a maturity of 10 years for $1,000. At the end of year nine, a year before maturity, the investor is entitled to $1,000 in principal plus $40 in interest payments, a total of $1,040 if the investor does not convert the bond into equity. However, the company's shares are now trading at $11 after a successful quarter; thus, 100 shares of the company are now worth $1,100 (100 share x $11 share price), surpassing the value of the bond. The investor is likely to convert the bond into equity, receiving 100 shares in the process, and he could sell them in the market for $1,100 in total.

2 CONVERTIBLE PREFERRED STOCKS

What is a Convertible Preferred Stock

Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date. Most convertible preferred stock is exchanged at the request of the shareholder, but sometimes there is a provision that allows the company, or issuer, to force conversion. The value of convertible preferred stock is ultimately based on the performance, or lack thereof, of the common stock.

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Convertible Preferred Stock

BREAKING DOWN Convertible Preferred Stock

Convertible preferred stock is used by corporations for fundraising purposes. Companies can raise capital in two ways, through debt or equity. Debt must be paid back regardless of the firm's financial situation, but it generally costs less to obtain after tax incentives. Equity gives up ownership but does not need to be paid back. Both forms of capital fundraising have their advantages and disadvantages, but there are hybrid securities available in the market to help investors carve out the perfect investment product. One such hybrid product is convertible preferred stock.

Preferred Stock

Equity gives shareholders ownership, which gives them voting rights, but they have no claim on assets if the company falters and liquidates. Preferred stock is a hybrid security that gives the shareholder a claim on assets in exchange for voting rights. It is not listed with common stock and trades at a different price due to its variations. There are many different types of preferred securities including cumulative preferred, callable preferred, participating preferred and convertibles. Convertible preferred stock provides investors with an option to participate in share price appreciation.

Convertible Preferred Stock

Preferred shareholders receive an almost guaranteed dividend; however, dividends for preferred shareholders do not grow at the same rate as they do for common shareholders. In bad times, preferred shareholders are covered, but in good times, they do not benefit from increased dividends or share price. This is the trade-off. Convertible preferred stock provides a solution to this problem. In exchange for a lower dividend, convertible preferred stock gives shareholders the ability to participate in share price appreciation.

At a certain price, convertible preferred stock can be converted to common shares. This price is called the conversion ratio. The conversion ratio is set by the company before the stock is issued. Convertible preferred shares priced at $100, with a conversion ratio of five, have a conversion price equal to the share price divided by the conversion ratio, or $20. This means the common share price needs to trade higher than $20 for the investor to gain value from the conversion.

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Related Terms

Preference Shares

Preference shares are company stock with dividends that are paid to shareholders before common stock dividends are paid out.

moreConvertible Adjustable Preferred Stock (CAPS)

Convertible Adjustable Preferred Stock (CAPS) is a preferred, floating rate issue whose interest rate is tied to Treasury security rates.

moreDividend Enhanced Convertible Stock - DECS

Dividend Enhanced Convertible Stock is a preferred stock that provides holders with premium dividends.

moreConversion Price

The conversion price is the price per share at which a convertible security, like corporate bonds or preferred shares, can be converted into common stock.

moreCumulative Preferred Stock

Cumulative preferred stock has a provision that says if any dividends have been missed in the past, they must be paid out to preferred shareholders first.

moreCallable Preferred Stock

A callable preferred stock is a type of preferred stock in which the issuer has the right to call in or redeem the stock at a preset price after a defined date