What Is Convertible Preferred Stock?
Convertible preferred stocks are preferred shares that include an option for the holder to convert the shares into a fixed number of common shares after a predetermined date.
Most convertible preferred stock is exchanged at the request of the shareholder, but sometimes there is a provision that allows the company, or issuer, to force the conversion. The value of a convertible preferred stock is ultimately based on the performance of the common stock.
Key Takeaways
- Convertible preferred stock is a type of preferred share that pays a dividend and can be converted into common stock at a fixed conversion ratio after a specified time.
- Convertible preferred stock is a type of hybrid security that has features of both debt and equity, arising from the dividend payment and conversion option, respectively.
- Once the common share trades above the conversion price, it may be worthwhile for the preferred shareholders to convert their preferred stock to common shares.
- After preferred shareholders convert their shares, they give up their rights as a preferred shareholder (no fixed dividend or higher claim on assets) and become a common shareholder (ability to vote and participate in share price appreciation).
Convertible Preferred Stock
Understanding Convertible Preferred Stock
Corporations use convertible preferred stock to raise capital. These securities are especially useful for early-stage companies as a financing medium that can offer greater flexibility to investors, making it a potentially more attractive financing option.
Preferred stock is a class of equity capital issued by a corporation that has a higher claim on assets and earnings than common stock. Preferred shares typically pay steady dividends, while common stock only pays dividends if they are approved by the board of directors based on financial performance of the firm. Additionally, preferred shares do not usually come with voting rights, as common shares do. As such, preferred stock is often thought of as a hybrid between a corporate bond and common stock.
Convertible preferred stock is distinguished by the fact that it contains an embedded option that allows the holder to convert it into a specified amount of common shares at some point in the future. This conversion option provides a potential upside for the holder, as the value of the common stock could increase over time, while still having the benefits of being a preferred stockholder.
Note however, because this is advantageous for investors, convertible preferred stock typically trades at a premium over regular preferred shares and may also carry a comparatively lower dividend rate.
Convertible Preferred Stock Terms
Commonly used terms when referring to convertible preferred stock are as follows:
- Par value: Face value of preferred stock, or the dollar amount payable to the holder if the company were to go bankrupt.
- Conversion ratio: The number of common shares that an investor receives at the time of conversion of a convertible preferred stock. The ratio is set by the company when the convertible preferred stock is issued.
- Conversion price: The price at which a convertible preferred share can be converted into common shares. Conversion price can be calculated by dividing the convertible preferred stock’s par value by the stipulated conversion ratio.
- Conversion premium: The dollar amount by which the market price of the convertible preferred stock exceeds the current market value of the common shares into which it may be converted. It may also be expressed as a percentage of the convertible preferred stock’s market price.
Example of Convertible Preferred Stock
Consider a convertible preferred stock issued by hypothetical company ABC Inc. at $1,000, with a conversion ratio of 10 and a fixed dividend of 5%. The conversion price is thus $100, and ABC’s common shares need to trade above this threshold for the conversion to be worthwhile for the investor. Even if the common shares are trading close to $100, it may not be worth it to convert since the preferred shareholder will be giving up their fixed 5% dividend and higher claim on company assets.
If the convertible preferred stock is trading at $1,000 and the ABC common shares are trading at $80, then the conversion premium would be $200 (i.e., (1,000 - ($80 × 10)) or 20% ($200 ÷ $1,000). If the common shares move up to $90, the conversion premium shrinks to $100, or 10%.
Thus, the conversion premium influences the price at which the convertible preferred stock trades in the market. A high conversion premium implies that the underlying common shares are trading well below the conversion price and there is little possibility of a profitable conversion. In this case, the convertible preferred stock will act more like a bond and will be susceptible to changes in interest rates. If the conversion premium is very low—implying that the common stock is trading quite close to the conversion price—the convertible preferred stock will be sensitive to changes in the underlying common shares (those of ABC, in this case) and will act like straight equity.
As the common shares rise, it becomes more attractive to convert. If the ABC common shares move to $110, the preferred shareholder gets $1,100 ($110 × 10) for each $1,000 preferred stock. That’s a gain of 10% if the investor converts and sells the common shares at $110.
The danger in converting is that the investor becomes a common shareholder, at the mercy of swings in the stock price. If the price of ABC stock falls to $75 after conversion, and the investor continues to hold the common shares, they would now own $750 ($75 × 10) in common shares for each preferred stock (worth $1,000) that they previously owned. This represents a notional loss of $250, and the investor no longer receives the 5% preferred stock dividend or preferential claim on assets.
How does a convertible preferred share differ from a regular preferred share?
The difference between a preferred share and a convertible preferred share is that the latter confers the option to convert into a set amount of common stock shares in the future. This option gives investors the benefit of capital appreciation while also enjoying the benefits of being a preferred shareholder. As a result, convertible preferred shares will often trade at a relative premium and offer a lower dividend rate.
How does a convertible preferred share differ from a convertible bond?
A convertible preferred share and a convertible bond are both securities that have the ability to be converted into common shares, but they differ in several key ways.
Convertible bonds are debt securities that can be converted into common stock, while preferred shares are a type of equity instrument. Because they are debt, in the event of a bankruptcy or liquidation, convertible preferred shareholders would have priority over convertible preferred shareholders, but both would have priority over holders of common stock.
Convertible preferred shares typically pay a fixed cash dividend out of a company’s retained earnings, while convertible bonds pay a coupon rate, which is a periodic interest payment booked as a liability for the firm.
Finally, most convertible bonds have a specified maturity date, while convertible preferred shares can exist as long as the company remains a going concern.
Why would investors buy convertible preferred stock?
Convertible preferred stock offers investors the benefits of both preferred stock and common stock. Investors initially get the stability, liquidation priority, and higher dividends of preferred stock, but they also have the option to convert their shares into common stock later if they believe that the price will go up.
This conversion feature can generate a potentially higher return on investment than investors would get with traditional preferred stock, while also offering a level of flexibility and control that is not possible with either preferred stock or bonds.
The Bottom Line
Convertible preferred stock is a type of preferred share that also grants the holder the option to convert them into a specified number of common stock shares. Combining features of both preferred and common stock, convertible preferred shares are a hybrid security that have the benefits of a steady, fixed dividend as well as the potential for capital appreciation via conversion.
This type of security is usually issued by companies that are looking to raise additional capital by offering investors more flexibility. The conversion price, or the number of common shares that one share of convertible preferred stock is good for, is determined at the time of issuance and may be adjusted subsequently by the issuer.
