Convertible Security

A convertible security is an investment that can be changed into another form. The most common convertible securities are convertible bonds or convertible preferred stock, which can be changed into equity or common stock. A convertible security pays a periodic fixed amount as a coupon payment (in the case of convertible bonds) or a preferred dividend (in the case of convertible preferred shares), and it specifies the price at which it can be converted into common stock.

Convertible securities usually have a lower payout than what comparable securities that do not have the conversion feature can offer. Investors are willing to accept the lower payout due to the potential profit from sharing in the appreciation of a company's common stock through the conversion feature.

The conversion value can be determined similarly to a call option on the common stock. The conversion price, the preset price at which the security can be converted into common stock, is usually set at a price higher than the stock's current price. If the conversion price is closer to the market price, it has a higher call value. The underlying security is valued based on its par value and coupon rate. The two values are added together for a complete valuation.

The price of the underlying common stock heavily influences the performance of a convertible security. The degree of correlation increases as the stock price approaches or exceeds the conversion price. Conversely, if the stock price is far below the conversion price, the security is likely to trade as a straight bond or a preferred share, since the prospects of conversion are viewed as remote.

A company with a current common stock price of $5 per share wants to raise some additional capital through a 10-year bond offering. Based on the company's credit rating, the interest rate is set at 8%. The chief financial officer (CFO) determines that the interest rate can be reduced to 6% by adding a conversion option at $10 per share. On a $1 million offering, the company saves $20,000 per year.

A $1 million investor receives total interest payments of $600,000 instead of the $800,000 payable on a non-convertible bond. If the stock price has risen to $12, the investor makes the additional $200,000 as a capital gain. Any increase in stock price above $12 results in additional profit. The investor has the flexibility to take additional profits based on market valuation at any time during the bond's 10-year life span.

Sometimes, the company issuing the securities wants to be in a position to force the investor's hand. The company does this by adding a call feature that allows it to redeem the bonds based on criteria set at issuance. A common example is to make the bonds callable at or near the conversion price. The company eliminates interest expense, while the investor receives either return of capital or common stock equal to the initial investment.