Quick Answer
Two extra features refine convertible preferred: an anti-dilution covenant that resets the conversion ratio after a stock split so the conversion value is unchanged, and a sinking fund that requires the issuer to retire shares over time, which lowers credit risk but adds call risk.
Both features protect a different party from a different risk: anti-dilution protects the holder's conversion feature from being watered down, while a sinking fund protects the holder's income stream by forcing the issuer to plan for redemption.
What Is the Anti-Dilution Agreement (Covenant)?
Virtually all convertible preferred stock is issued with an anti-dilution covenant that protects holders from dilution caused by stock splits and stock dividends.
- When a stock split or stock dividend occurs, the conversion ratio is adjusted proportionally
- Without anti-dilution protection, a 2-for-1 split would halve the value of the conversion feature
- The anti-dilution adjustment protects the holder, not the issuer
How Does the Adjustment Work?
After a stock split:
- The conversion ratio increases (more shares received)
- The conversion price decreases (lower price per share)
- The conversion value stays the same before and after the split
Worked Example
Original terms: $100 par, conversion price $50, conversion ratio = 2 shares
After a 2-for-1 stock split:
- New conversion price: $50 / 2 = $25
- New conversion ratio: $100 / $25 = 4 shares (or simply 2 x 2 = 4)
- If common was at $50 pre-split and $25 post-split:
- Pre-split conversion value: 2 x $50 = $100
- Post-split conversion value: 4 x $25 = $100
- Conversion value is unchanged: the holder is protected
Another Example: 3-for-1 Split
Original: $100 par, conversion price $30, conversion ratio = 3.33 shares
After 3-for-1 split:
- New conversion price: $30 / 3 = $10
- New conversion ratio: $100 / $10 = 10 shares
Exam Tip: Gotchas
- Anti-dilution adjustments protect the HOLDER, not the issuer.
- After a stock split, the conversion ratio increases and the conversion price decreases proportionally.
- To find the post-split conversion ratio from the pre-split ratio, just multiply the ratio by the split factor.
What Are Sinking Fund Provisions?
Some preferred stock issues include a sinking fund requiring the issuer to retire a portion of outstanding shares each year.
- The issuer sets aside money periodically to repurchase shares on the open market or call them at a specified price
- Sinking funds reduce risk for the investor by ensuring the issuer systematically retires the obligation
- Works the same way as sinking funds on bonds
How Do Sinking Funds Affect the Investor?
| Factor | Impact |
|---|---|
| Credit risk | Reduced (issuer is gradually retiring the obligation) |
| Liquidity | Reduced (fewer shares outstanding over time) |
| Call risk | Increased (issuer may call specific shares for the sinking fund) |
| Price stability | Improved (regular repurchases provide price support) |
Key point: A sinking fund is generally investor-friendly because it forces the issuer to commit funds to retire the preferred shares, reducing the risk that the issuer cannot meet its obligations.
Exam Tip: Gotchas
- Sinking funds reduce credit risk for the investor but introduce some call risk on individual shares.
- A sinking fund on preferred stock works the same way as on bonds; the exam may test this comparison.
What Should You Check on Exam Day?
- Anti-dilution adjustments protect the holder, and trigger on stock splits and stock dividends.
- After a split, multiply the pre-split conversion ratio by the split factor to get the new ratio.
- Conversion value stays constant across a split; the ratio and price move to offset each other.
- A sinking fund lowers credit risk but raises call risk on specific shares, the same tradeoff as a bond sinking fund.