Quick Answer
Convertible bonds and preferred shares can be exchanged for common stock at the holder's option. The conversion ratio comes from par value and the contractual conversion price. Market parity instead uses the convertible's current market price. Compare the value of shares received with the convertible's sale value before deciding whether to convert; conversion price alone cannot decide.
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 are the two types of convertible securities. Each can be exchanged for a specified number of common shares
- Common stock is the security a holder receives on conversion, so common stock itself does not carry a conversion feature. Treasury bonds do not carry one either
- 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: compare the value of the common shares received with the convertible's current market value. The contractual conversion price is not the same as market parity.
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
A convertible bond converts into 20 shares and trades at $1,100:
- Parity price = $1,100 / 20 = $55 per share
- If the common stock trades above $55, the shares received on conversion are worth more than the bond's $1,100 market value before costs
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 market-value comparison point. The conversion price is a contractual term, while parity depends on the convertible's current market price.
How the Convertible's Price Behaves
- When the stock price sits well below the conversion price, the conversion feature has little value. The convertible trades mainly on its bond or preferred characteristics: credit quality, interest rates, and the fixed income stream
- When the stock price sits well above the conversion price, the conversion feature dominates. The convertible's market price tracks the common stock closely and behaves more like equity than fixed income
- Between the two zones, the convertible carries some of both: a fixed-income floor plus growing sensitivity to the stock as the stock price approaches the conversion price
Exam Tip: Gotchas
Conversion price and parity answer two different questions. Conversion price marks the zone the convertible trades in (bond-like below it, equity-like well above it). Parity marks the break-even point for the conversion decision itself. A question about how the convertible's PRICE behaves points to conversion price; a question about whether to convert points to 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, conversion delivers common shares worth less than the convertible's market value; the investor may hold for income or sell depending on their objectives
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, the conversion value exceeds the convertible's market value, making conversion economically attractive before costs.
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
What Should You Check on Exam Day?
- Can you state the conversion ratio formula and use it to find the number of shares received?
- Can you explain why a convertible trades like a bond well below the conversion price and like equity well above it, and how that differs from parity?
- Do you know why conversion is always at the investor's option, not the company's?
- Can you explain why convertible securities carry lower yields than non-convertible equivalents?
- Do you know when it becomes profitable for an investor to convert?