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By Investopedia AAA

Equities - Shares from Conversion

Sometimes you can receive stock in another way: conversion. As discussed earlier, some bonds or preferred shares can be converted into common shares.

  • These fixed-income instruments (that is, securities that pay steady interest or dividends) with a convertibility feature are usually issued with rates below the prevailing yields for non-convertible bonds.
  • Their prices are also structured so that, if you converted the bonds to common shares the day after you bought them, you would probably lose a sizable amount of money.
  • This is done by setting the conversion price of the common share higher than the market price of that share.

Let's say you bought a bond for $1,000. It is convertible to 50 shares of common stock. The conversion price, then, is $20 per share ($1,000/50 shares). You could probably buy those shares from any brokerage for $15 per share.

Why Convert?
So why would you do the conversion? Remember, not only do the conversion terms mean you have to hold on to these bonds for some period before they can be favorably exchanged for stock, these bonds also feature a lower interest rate than straight bonds. How did a market form for these securities?

According to investment bankers at Tennessee-based Mercer Capital, the investor trades coupon income for upside potential. The conversion price may be parked at $20, but the market price changes almost every day. If the company is a drug maker and it announces a cure for Parkinson's disease, the share price could go from $15 to $20 in minutes. By the end of the day, there is no limit to how high it can go. If it goes up to $50, just to pick a number, the investor who can convert his debt into shares priced at $20 suddenly looks like a genius.

What Do Companies Get Out of It?
Meanwhile, the issuing company benefits too. Debt is almost always cheaper to issue than equity. Not only does the company get to issue debt instead of equity and thus keep its total cost of capital low, but it also issues that debt at a lower rate than it would have to if its bonds traded without a convertibility feature.

The downside for the issuer is that, if its stock's market price rises faster than was anticipated at the time the convertibility clause was written, there could be a rush to trade the bonds in for common shares. This could lead to the need to dump into the market a large amount of shares that the company had been holding as treasury stock, and this could lead to dilution, meaning there are suddenly more shares of the same rights to the company's assets and cash flows, which in turn means that each share is worth a little less.

Convertibles and Arbitrage
Convertible securities are tools used in arbitrage, the simultaneous buying and selling of a security. The purpose of arbitrage is to take advantage of small discrepancies in market prices.

If a stock is trading at $10 on the New York Stock Exchange and at $10.01 on the Pacific Stock Exchange, an arbitrageur - aided by a specialized computer application - can buy 1,000,000 shares in New York while selling 1,000,000 shares at the same time in San Francisco. He makes a one-cent profit 1,000,000 times, or $10,000, in one second.

So let's say the common stock price for the hypothetical pharmaceutical company (with the cure for Parkinson's) does not go to $50. It just goes to $20.01. An alert arbitrageur will spend $10,000,000 to buy 10,000 convertible bonds with the $1,000 face value. He converts them to 500,000 common shares (50 shares per bond times 10,000 bonds), each convertible at $20. He then sells those 500,000 shares for $20.01, making a one-penny profit 500,000 times, or $5,000 for doing almost nothing and taking no time to do it.

Still, it is important to not be too glib about arbitrage. It is the proof that exchange-traded securities operate in an efficient and transparent market.

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