Quick Answer
Convertible securities are preferred stock or bonds that investors can exchange for common shares at their own option. The conversion ratio equals par value divided by conversion price, and parity is the convertible's market price divided by that ratio. Convertibles carry lower yields, and converting becomes profitable once the stock price exceeds parity.
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
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 what parity means and how to calculate it?
- 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?