Buying stocks always poses the risk of losing money, but avoiding stocks altogether means missing out on the opportunity to make good profits. There is one security, however, that may help solve this dilemma for some investors: convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation. Here we review what these securities are, how they work and how to determine when a conversion is profitable.

What Convertible Preferred Shares Are

These shares are corporate fixed-income securities that the investor can choose to turn into a certain number of shares of the company's common stock after a predetermined time span or on a specific date. The fixed-income component offers a steady income stream and some protection of the investors' capital. However, the option to convert these securities into stock gives the investor the opportunity to gain from a rise in the share price.

Convertibles are particularly attractive to those investors who want to participate in the rise of hot growth companies while being insulated from a drop in price should the stocks not live up to expectations.

The Opportunity for the Investor

To demonstrate how convertible preferred shares work and how the shares benefit investors, let's consider an example. Let's say Acme Semiconductor issues 1 million convertible preferred shares priced at $100 a share. These convertible preferred shares (as these are fixed-income securities) give the holders priority over common shareholders in two ways. First, convertible preferred shareholders receive a 4.5% dividend (provided Acme's earnings continue to be sufficient) before any dividend is paid to common shareholders. Second, convertible preferred shareholders will rank ahead of common shareholders in the return of capital if Acme ever went bankrupt and its assets had to be sold off. That said, convertible preferred shareholders, unlike common shareholders, rarely have voting rights.

By buying Acme convertible preferred shares, the worst investors would ever do is receive a $4.50 annual dividend for each share they own. But these securities offer the owners the possibility of even higher returns: if the convertible preferred shareholders see a rise in Acme's stock, they may have the opportunity to profit from that rise by turning their fixed-income investment into equity. On the reset date, shareholders of Acme convertible preferred shares have the option of converting some or all of their preferred shares to common stock.

Determining the Profit of Converting

The conversion ratio represents the number of common shares shareholders may receive for every convertible preferred share. The conversion ratio is set by management prior to issue, typically with guidance from an investment bank. For Acme, let's say the conversion ratio is 6.5, which allows investors to trade in the preferred shares for 6.5 shares of Acme stock.

The conversion ratio shows what price the common stock needs to be trading at in order for the shareholder of the preferred shares to make money on the conversion. This price, known as the conversion price, is equal to the purchase price of the preferred share, divided by the conversion ratio. So for Acme, the market conversion price is $15.38 ($100/6.5).

In other words, Acme common shares need to be trading above $15.38 for investors to gain from a conversion. If the shares do convert and drop below $15.38, the investors will suffer a capital loss on their $100-per-share investment. If common shares finish at $10, for instance, then convertible preferred shareholders' receive only $65 ($10 x 6.5) worth of common share in exchange for their $100 preferred shares. (The $100 represents the parity value of the preferred shares.)

The Conversion Premium

Convertible preferred shares can be sold on the secondary market, and the market price and behavior is determined by the conversion premium, the difference between the parity value and the value of the preferred shares if the shares were converted. As we show above, the value of the converted preferred share is equal to the market price of common shares multiplied by the conversion ratio. Let's say Acme's stock currently trades at $12, which means the value of the preferred shares is $78 ($12 x 6.5). As you can see, this is well below the parity value. So, if Acme's stock is trading at $12, the conversion premium is 22% [($100 - $78)/100].

The lower the premium, the more likely the convertible's market price will follow the common stock value up and down. Higher-premium convertibles act more like bonds since it's less likely that there will be a chance for a profitable conversion. That means that interest rates too can impact the value of convertible preferred shares: like the price of bonds, the price of convertible preferred shares will normally fall as interest rates go up: the fixed dividend looks less attractive than the rising interest rates. Conversely, as rates fall, convertible preferred shares become more attractive.

The Bottom Line

Convertibles appeal to investors who want to participate in the stock market without feeling as though they are taking wild risks. The securities trade like stocks when the price of common shares moves above the conversion price. If the stock price slips below the conversion price, the convertible trades just like a bond, effectively putting a price floor under the investment.

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