What is a Convertible Security? Definition, How It Works, Example

A convertible security is an investment that can be changed into another form, such as convertible preferred stock that converts to common stock.

A convertible security is an asset or investment instrument that can be converted into a different form than its initial form. A preferred stock that can be changed into a common stock is an example of a convertible security. Convertible security has characteristics of both debt and equity. Generally, major financial investment options are not convertible securities; major convertible securities include convertible bonds and preferred shares.

Convertible securities like preferred stocks can be beneficial for investors. They offer the potential for capital appreciation through conversion into common stock while also providing a fixed income stream or dividend, similar to debt securities. The conversion price is the fixed price at which you can turn the convertible security into a common stock.

What are the Types of Convertible Securities?

Here are some examples of convertible securities:

1. Convertible Bonds: Convertible bonds are debt securities that you can convert into a specified number of the issuing company’s common stock shares at a set price. They pay a fixed interest rate, like traditional bonds, but also offer the chance for capital appreciation through conversion. Convertible debentures are also a type of convertible bond.
   
2. Convertible Preferred Stock: Convertible preferred stocks are hybrid securities that combine aspects of both preferred and common stock. They provide a fixed dividend like preferred stock but also let you convert it into common stock at a specified price. Due to the conversion option, the dividend rate and capital appreciation through stock price rise are generally lower than that of non-convertible preferred stocks.
   
3. Warrants: These long-term options allow you to buy the company’s stock at a specific price before they expire. Companies often issue them with bonds or preferred stock.
   
4. Convertible Notes: These are short-term debt instruments that convert into equity, usually during a future financing round. Startups commonly use them for financing.

What is an example of a convertible bond?

For example, a tech startup issues convertible preferred stock to raise capital. An investor buys 100 shares of TechInnovate’s convertible preferred stock at $50 per share, which comes with a fixed annual dividend of $2 per share.

After a few years, the startup’s business grows significantly, and its common stock price rises to $100 per share. The terms of the convertible preferred stock allow the investor to convert each preferred share into two common shares.

Seeing the increased value, the investor decides to convert their 100 shares of preferred stock into 200 shares of common stock (100 shares * 2 conversion rate). Now, instead of receiving the fixed dividend, the investor benefits from owning a common stock that has appreciated in value, giving them the potential for further capital gains as the company continues to grow.

What is the Structure and Mechanism of Convertible Securities?

Before investing in convertible securities, investors must know its structure and mechanism. Here are some of the points that will help you understand convertible securities better:

Conversion Ratio and Conversion Price

• Conversion Ratio: The conversion ratio determines the number of common shares an investor will receive upon converting the convertible security. For example, a conversion ratio of 20 means that one convertible bond can be converted into 20 shares of common stock.
  
• Conversion Price: This is the predetermined price at which the convertible security can be converted into common stock. It is calculated by dividing the convertible security’s par value by the conversion ratio.

Embedded Options

Convertible securities contain an embedded option, which is the right to convert the security into common stock. This option has value and contributes to the overall value of the convertible security. The value of the embedded option depends on factors such as the stock price, interest rates, and time to maturity:

• Call Option: From the issuer’s perspective, the conversion feature is similar to a call option on the company’s stock. The issuer has the right, but not the obligation, to call the convertible security and force conversion at a predetermined price.
  
• Put Option: Some convertible securities may include a put option, which gives the holder the right to sell the security back to the issuer at a predetermined price. This feature provides additional flexibility for investors.

What are the Benefits of Convertible Securities?

• Upside Potential: One of the primary advantages of convertible securities is the potential for capital appreciation. If the underlying stock price increases, the convertible security can be converted into common stock, allowing investors to participate in the company’s growth. This upside potential is similar to owning common stock but with limited downside risk.
  
• Downside Protection: Convertible securities also help you protect from the downside. Let’s say the stock price declines; in this case, you can hold your convertible security and continue receiving interest or dividend payments as a bond. This provides a safety feature for investors during market volatility.
  
• Diversification: You can use convertible securities to diversify an investment portfolio as they offer exposure to both the equity and debt markets, potentially reducing overall portfolio risk. By combining the potential for capital appreciation with the stability of debt, you can create a more balanced investment mix.
  
• Yield: Due to the conversion option, convertible securities typically offer a coupon rate or dividend yield lower than traditional bonds. However, this yield still provides investors with a steady income stream while they wait for the stock price to appreciate.
  
• Tax Advantages: In some cases, convertible securities may offer tax advantages compared to traditional equity investments. The interest payments on convertible bonds may be tax-deductible for the issuing company, which can positively impact its overall tax position.

What are the Risks Associated with Convertible Securities?

• Credit Risk: No one knows if one company can default on its obligation to pay interest or redeem the convertible security at maturity. That is the risk with debt instruments. So, you have to look for a financially stable company with low credit risk for convertible securities.
  
• Interest Rate Risk: The economy’s financial conditions, like inflation, can majorly influence interest rates. If the interest rate rises, the value of the convertible security may decline, as investors can earn higher returns on traditional bonds.
  
• Dilution Risk: When a convertible security is converted into common stock, the number of outstanding shares increases, which can dilute the ownership stake of existing shareholders.
  
• Opportunity Cost: Investors who hold convertible securities may miss out on potentially higher returns from investing directly in common stock if the stock price appreciates significantly.
  
• Call Risk: Some convertible securities have a call feature, which allows the issuer to redeem the securities before the maturity date. This can limit the investor’s upside potential if the stock price rises substantially.

What is the Process of Issuing Convertible Securities?

Issuance Procedures

• Underwriting: The company collaborates with an investment bank to underwrite the issuance of convertible securities. The underwriter assists in determining the terms of the issue, including the conversion price, interest rate, and maturity date.
  
• Regulatory Filings: The company must comply with applicable securities regulations, including filing registration statements with regulatory authorities. This procedure can be different for different countries and locations.
  
• Investor Marketing: The underwriter markets the convertible securities to potential investors, highlighting the benefits and risks of the investment.
  
• Pricing and Allocation: The issue price of the convertible securities is determined, and the securities are allocated to investors.

Role of Issuers and Investors

• Issuers: Companies issue convertible securities to raise capital while maintaining financial flexibility. By offering the conversion option, they can attract investors who are seeking both income and growth potential.
  
• Investors: Investors purchase convertible securities for various reasons, including income generation, capital appreciation potential, and risk management. They weigh the benefits of the conversion option against the potential dilution of ownership.

Are convertible securities debt or equity?

Convertible securities are hybrid securities that combine features of both debt and equity. They provide regular interest payments or dividends like debt instruments and offer the potential for capital gains like equity investments. How they are classified for accounting purposes depends on the issuer’s specific circumstances and intent.

What is the Impact of Convertible Securities on Financial Markets?

Influence on Corporate Financing

Convertible securities provide companies with a flexible way to raise capital. By offering investors the potential for equity participation, companies can often secure financing at a lower interest rate compared to traditional debt instruments. The issuance of convertible securities Companies need to consider this dilution effect when issuing convertible securities carefully, as after the dilution, the ownership stake of existing shareholders

Market Behavior and Trends

Convertible securities appeal to investors with diverse risk profiles. Those seeking income can focus on the bond-like features, while those seeking growth potential can benefit from the conversion option. The attractiveness of convertible securities can also vary depending on market conditions. In rising interest rate environments, convertible bonds may become less appealing as investors can earn higher returns on traditional bonds.

Also, Convertible securities can be affected by equity and debt market volatility. Their value can fluctuate based on changes in interest rates, stock prices, and market sentiment.

What is the Comparison with Other Financial Instruments?

Comparison with Straight Bonds

• Yield: Convertible bonds typically offer a lower coupon rate than traditional straight bonds due to the embedded conversion option. This lower yield reflects the potential for capital appreciation through conversion.
  
• Credit Risk: Convertible bonds generally have lower credit risk than straight bonds due to the equity component. Investors are more likely to convert the bonds into stock if the company faces financial difficulties.
  
• Liquidity: Convertible bonds often have lower liquidity than straight bonds, as both debt and equity market factors influence their price.

Comparison with Common Stocks

• Income: Convertible bonds offer a fixed income stream in the form of interest payments, while common stocks typically do not provide regular income.
  
• Ownership: Common stockholders have ownership rights in the company, including voting rights, while convertible bondholders do not have voting rights until they convert the bonds into common stock.
  
• Risk: Common stocks generally have higher risk compared to convertible bonds, as they do not offer the downside protection of a fixed income component.
  
• Upside Potential: Convertible bonds offer limited upside potential compared to common stocks, as the conversion price is often set at a premium to the current stock price.

Braden Chase

Braden Chase is an investor, trading specialist, and former research specialist for Forex.com who helps aspiring investors develop the confidence and habits they need to make an income from the market. Braden has served as a registered commodity futures representative for domestic and internationally-regulated brokerages and has also spoken & moderated numerous forex and finance industry panels across the globe.

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