Definition of Convertible Securities
Convertible securities are financial instruments, such as bonds or preferred stock, that can be exchanged for a predetermined number of another form of security, usually common stock, at certain times during the holder’s life. Typically, this conversion feature is at the discretion of the security holder and is done under pre-established conditions.
Examples
Convertible Bond: A bond issued by a company that can be converted into a predefined number of its shares at the discretion of the bondholder. For instance, a $1,000 convertible bond might be convertible into 20 shares of the issuing company’s stock.
Convertible Preferred Stock: Preferred shares that can be converted into a specified number of common shares. For example, a corporation might issue convertible preferred stock that can be exchanged for common shares at a 1:1 ratio.
Government Convertible Security: A government bond in which the holder has the right to convert the holding into new stock instead of obtaining repayment. For instance, a government could issue a 10-year convertible security that can be converted into government shares after five years under certain market conditions.
Frequently Asked Questions
Q: What are the advantages of convertible securities for investors? A: Convertible securities offer investors the potential for upside participation in the equity markets (through conversion to common stock) along with the fixed-income characteristics of bonds or preferred stock.
Q: How do companies benefit from issuing convertible securities? A: Companies benefit because convertible securities can offer lower interest rates compared to non-convertibles due to the added conversion feature and can help delay equity dilution.
Q: What are the risks associated with convertible bonds? A: The primary risks include interest rate risk, credit risk, and the risk that the underlying stock does not perform well enough to make conversion attractive.
Q: When is it advantageous for an investor to convert their convertible securities? A: It is advantageous if the market price of the common stock exceeds the conversion price, making the conversion valuable and beneficial.
Q: What is meant by the conversion ratio? A: The conversion ratio is the number of common shares that can be obtained for each convertible bond or preferred share. It is defined at the time of issue.
Related Terms
- Compound Instrument: A financial instrument that comprises both a liability and an equity component. Convertible securities are classic examples of compound instruments.
- Equity: Ownership interest in a company, usually in the form of common or preferred stock.
- Debt Security: A financial instrument representing a loan made by an investor to an issuer (such as a bond), characterized by regular interest payments and the return of principal.
- Preferred Stock: A class of ownership in a corporation with a fixed dividend, receiving priority over common stocks in the payment of dividends and upon liquidation.
- Convertible Arbitrage: A trading strategy that typically involves taking long positions in convertible securities and short positions in the underlying common stocks.
Online References
- Investopedia: Convertible Securities
- MarketWatch: Convertible Bonds
Suggested Books for Further Studies
- “Convertible Securities: The Latest Developments for Cost-Effective Financing” by John M. Marshall
- “Convertible Bond Markets” by Jens H. E. Christensen
- “Convertible Bonds: Risk Management, Analysis, and Structuring” by Kevin B. Connolly
Accounting Basics: “Convertible Securities” Fundamentals Quiz
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