You've seen that preferred stock pays a fixed dividend and that common stock offers unlimited upside. Convertible securities bridge these two worlds; they start as one type of security but can be exchanged for common stock.
What Are Convertible Securities?
- Convertible preferred stock and convertible bonds can be exchanged for a specified number of common shares
- The conversion is at the investor's option - the company cannot force conversion
- Convertible securities offer lower yields than their non-convertible equivalents because investors pay for the conversion privilege through reduced income
- Conversion does not guarantee a profit: it only becomes profitable once the stock price rises above parity, and the investor still has to choose to convert at the right time
Key Conversion Terms
| Term | Definition | Formula |
|---|---|---|
| Conversion ratio | Number of common shares received per convertible security | Par Value / Conversion Price |
| Conversion price | Effective price paid per common share upon conversion | Par Value / Conversion Ratio |
| Parity | Point where the convertible's market value equals its conversion value | Market Price of Convertible / Conversion Ratio |
Example
A convertible bond has a $1,000 par value and a conversion price of $50:
- Conversion ratio = $1,000 / $50 = 20 shares
- If the bond is trading at $1,100: Parity price = $1,100 / 20 = $55 per share
- If the common stock is trading above $55, converting is profitable
Exam Tip: Gotchas
Know the conversion ratio formula cold: Par Value / Conversion Price. The exam loves to give you a bond's par value and conversion price, then ask how many shares you receive. Also remember that parity is the break-even point - convert only when the stock price exceeds parity.
When Does an Investor Convert?
- An investor converts when the common stock price rises above parity
- At that point, the common shares received are worth more than the convertible security's market value
- Below parity, the investor holds the convertible for its income (dividends or interest)
Think of it this way: The convertible security has a split personality. When the stock price is low, it behaves like a bond or preferred stock, paying you steady income. When the stock price climbs above parity, it starts acting like a stock option, and you convert to capture the upside.
Exam Tip: Gotchas
Conversion is always at the INVESTOR'S option, not the company's. The exam may try to trick you with scenarios where the issuer "forces" conversion. Remember: the holder decides.
The Tradeoff
| Feature | Convertible Security | Non-Convertible Equivalent |
|---|---|---|
| Yield | Lower | Higher |
| Upside potential | Yes (through conversion) | No |
| Inflation protection | Some (common stock tends to keep pace) | None |
| Downside protection | Fixed income provides floor | Fixed income provides floor |
Exam Tip: Gotchas
Convertible securities carry LOWER yields than non-convertible versions of the same security. The investor accepts less income in exchange for the option to convert to common stock. This is a frequently tested concept.
Putting It Together
Convertible issued with low yield → Stock price rises above parity → Investor converts → Receives common shares → Gains upside potential