DEFINITION of 'Deferred Equity'

Deferred equity is a type of security, such as preferred shares or convertible bonds, that can be exchanged in the future at a predetermined price for another type of instrument, such as shares of common stock. These securities are known as deferred equity because of their equity component, and the expectation that they will be converted into stock shares in the future. They are also called convertibles, usually bonds or preferred shares that can be converted into common stock.

BREAKING DOWN 'Deferred Equity'

A convertible bond is an example of deferred equity since the bondholder will exercise the convertible option and convert the bond to shares of common stock if the price of the underlying shares rise to a profitable level, typically 25% higher than the price at issuance. Issuing convertible bonds is a way for a company to offer a low coupon yield, but entice investors with a value-added component. Each convertible bond has a conversion ratio that denotes the number of shares of common stock the bond holder can receive upon conversion. The ratio may be stable or it might change over the bond’s life, but it is always adjusted for stock splits and stock dividends. A conversion ratio of 50 means that for every $1,000 of par value, or face value of the bond, the bond holder converts, he or she will obtain 50 shares of common stock. Most convertible bonds have intermediate-term maturities.

In addition, most convertible bonds have a call provision, i.e., the company can force investors to convert the bond into common stock, usually when the stock price rallies to a high level. Investors who wish to convert must do so at that price, even if they would rather wait for an even higher price. The upside is not unlimited. However, the investor will receive the par value of the bond at maturity, even if the share price falls dramatically and thus, it supplies some downside protection.

A convertible security is a debt instrument that can be converted to equity, thus deferring the equity until the time that the conversion to common stock, for example, takes place.

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