What is a '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.

BREAKING DOWN 'Convertible Security'

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.

Valuation

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.

Illustration

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.

Callable Securities

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.

RELATED TERMS
  1. Forced Conversion

    A forced conversion allows an issuing company to make a security ...
  2. Conversion

    A conversion is the exchange of a convertible type of asset into ...
  3. Deferred Equity

    Deferred equity is a security, such as preferred shares or convertible ...
  4. Conversion Premium

    A conversion premium is the amount by which the price of a convertible ...
  5. Conversion Parity Price

    The conversion parity price is the price paid for converting ...
  6. Convertible Preferred Stock

    Convertible preferred stock includes an option for the holder ...
Related Articles
  1. Investing

    Introduction to Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
  2. Investing

    Convertible bonds: pros and cons for companies and investors

    Understand what effect convertible bonds have on investors and companies. Find out the advantages, disadvantages, and what the issue means from a corporate standpoint before buying in.
  3. Investing

    3 Best High-Yielding Convertible Bond Mutual Funds (LACFX, FACVX)

    LACFX,FACVX,VCVSX: Learn about three of the highest-yielding options available.
  4. Managing Wealth

    The Mandatory Convertible: A "Must Have" For Your Portfolio?

    Mandatory convertibles are a little understood security with some distinct advantages. Find out if they are right for you.
  5. Investing

    The Top 3 Convertible Bond ETFs for 2016 (CWB, ICVT)

    Obtain detailed information on the exchange-traded funds (ETFs) available for traders seeking ETF exposure to convertible bond investments.
  6. Investing

    The Top 6 Convertible Bond Funds for 2016

    Take a look at convertible bond mutual funds that are well-positioned heading into 2016, and why investors might consider a convertible fund portfolio.
  7. Investing

    Can a Bond ETF Work in a Rising Rate Environment?

    The CWB Convertible Securities ETF could be the perfect solution for a rising rate environment.
  8. Investing

    CWB: SPDR Barclays Convertible Secs ETF

    Read an in-depth analysis of the SPDR Barclays Capital Convertible Bond ETF, which tracks an index of high-growth potential convertible bonds.
  9. Investing

    Income Funds 101

    Income funds don't have to be bonds, there are plenty to choose from. Read up on the types of income funds and whether they fit your investment needs.
RELATED FAQS
  1. Where Does Stock From Convertible Bonds Come From?

    Find out how a debt instrument converts into shares of the issuer's common stock, at a set price and usually by a set date. ... Read Answer >>
  2. How is convertible bond valuation different than traditional bond valuation?

    Read about bond valuation, particularly the differences between how a traditional bond is valued and how a convertible bond ... Read Answer >>
  3. What are 'death spiral' convertible bonds?

    Conventional convertible bonds give the bondholder the right to exchange the bond for a certain amount of the issuer's common ... Read Answer >>
  4. What is stock dilution?

    Stock dilution occurs when company actions reduce the ownership percentage of current shareholders. Read Answer >>
Trading Center