The financial markets are afloat with a broad variety of different security types, and understanding what each of them is can help you make informed investment decisions, and ensure sound financial planning. Convertible shares are a category of financial securities that many in the market deal with.
Having knowledge of this investment category, therefore, is a great way to expand one’s understanding of the wider market itself.
Just as every class of security, convertible shares hold advantages unique to themselves, along with inherent risks. Knowing what these realities are would give market players a tremendous edge over other investors in the game.
In this article, we take a birds-eye view of this concept and uncover everything there is to know about these exciting market instruments.
Overview
As its name suggests, convertible shares are essentially shares that its holders can choose to convert into ordinary shares if they choose to do so. Companies typically offer this to investors in order to give them more flexibility.
Often, investors are torn between choosing ordinary shares or bonds, as instruments to invest in. Shares of a convertible nature offer a sound middle ground, where they have the option to convert the security at a later date.
Convertible stock typically comes with certain terms that trigger the conversion process. These terms vary across companies. An example is convertible stocks turning to ordinary stocks following a business merger or IPO.
Not only do convertible stocks offer a higher degree of flexibility to investors than non-convertible shares do, but are safer and less volatile, while also having the potential of price appreciation by conversion to ordinary stocks.
What are Convertible Preferred Shares?
Convertible preference shares are among the most common examples of convertible shares. In order to understand what exactly a convertible preferred share is, we need to step back and understand what a preferred share is, and how it works.
Preferred stock is much like ordinary stock, in the sense that it reflects a type of ownership in the company.
Privileges of Preferred Shareholders
Unlike ordinary shareholders, preferred shareholders possess certain privileges.
Some of these privileges normally include:
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Fixed income stream
This is similar to a dividend in regular intervals, regardless of the company’s financial performance. However, this limits higher capital appreciation growth for those holding preferred shares.
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Priority claims in bankruptcy
Preferred shareholders get preferential treatment in the event of bankruptcy. Like the fixed income stream, this too makes it similar to a bond. However, unlike bonds, these come with ownership and voting rights.
A convertible preferred share is simply a preferred share, as described above, which comes with the inherent possibility of being converted to an ordinary share, at a later date. A conversion would grant them exposure to price rises in the market.
Convertible preferred shares are ideal for those who have a low-risk tolerance and desire the flexibility of making the decision to become ordinary shareholders at a time of their own choosing.
What are Convertible Bonds?
Just like stocks, companies can issue bonds for financing their operations. This is essentially debt, for which bondholders would be receiving interest payments at a specified interest rate, without having ownership of the company.
When, instead of regular bonds, an investor buys a convertible bond, they may convert it into an ordinary stock if the option is exercised. This is typically done in the case of the stock price rising beyond the conversion price.
These securities are converted to shares if the holder deems it worthwhile to be exposed to the price gains of the stock. If not, they may receive regular interest payments, and redeem the bond at its face value upon maturity.
Convertible Shares vs Convertible Bonds
While both convertible shares and convertible bonds are securities that can be converted into ordinary shares, they do hold a number of key differences. These are as follows:
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Structure at the origin
Convertible stocks start off as a form of ownership in the company, with distinct privileges that can be converted into ordinary ownership.
Convertible bonds do not start off as ownership claims. They are loans to the company, where holders initially do not have ownership and voting rights, and only do so upon conversion.
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Maturity date
Convertible stocks do not have an assigned maturity date, so investors can indefinitely hold on to them, while always having the option to convert them into ordinary shares.
Convertible bonds have a maturity date, and can only be converted before that. If the conversion is not exercised, the bondholder can redeem the security at face value by that date.
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Liquidity
Convertible stocks are usually more liquid than convertible bonds because they are traded on listed exchanges, and thus have a ready market active in their buying and selling.
Convertible bonds have lower liquidity because they are not listed, and thus can only be transacted on over-the-counter platforms, which complicates their buying and selling.
How Convertible Preferred Shares Benefit Investors?
Holding convertible preferred shares bring tremendous benefits to investors. Six of the most compelling plus points of these financial instruments are listed out below:
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Flexibility
Convertible preferred shares are highly flexible, as they give holders the right to benefit from stable income and other privileges, while also giving them the option to convert to ordinary shares to enjoy potential price climbs.
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Return of Capital
Those holding convertible preferred shares can enjoy capital appreciation, as these securities climb in value when the ordinary stock rises in price. As a result, it is more advantageous than a bond investment.
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Stable income
Convertible preferred shares offer a steady income stream, more stable than dividends. If the share price and its dividends become more compelling, the conversion can simply be exercised, making it a win-win investment.
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Protection during bankruptcy
If a convertible preferred share is not converted, in the event of bankruptcy, its holders will receive preferential treatment over ordinary shareholders, when the company’s assets are being liquidated.
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Portfolio diversification
If one were to invest in convertible preferred shares, their investment portfolio could enjoy diversification benefits such as risk reduction. Moreover, the convertible aspect would enhance this aspect of the investment.
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Taxation benefits
Normally, income from convertible preferred shares is taxed by a lower percentage than income derived from dividend payments. This gives clear tax benefits to its holders.
How does the Conversion Ratio work?
The conversion ratio is an essential part of the convertible security set up. In fact, one cannot determine how do convertible stocks work, without referring back to the conversion ratio.
The conversion ratio simply tells us how many shares of ordinary stock would each convertible shares deliver if its holder chooses to convert them.
For example, a certain convertible stock with a ratio of 3:1 would mean every 3 convertible shares would be converted to a single ordinary stock, and 300 would convert into 100.
It is evident, therefore, that the exercising of the convertible would rest upon the conversion price at the time. Investors would only do so if and when they can avoid a capital loss.
Looking at a real-life example, Wells Fargo & Company, (NYSE: WFC) has a preferred convertible stock that has a conversion ratio of 1:32. This means every convertible preferred share would deliver a single ordinary stock.
Pricing also plays a role in the conversion ratio, and whether or not they are exercised. WFC is currently priced at $46, whereas its convertible preferred share is at almost $1200.
If a convertible stock is priced at $200, with a conversion ratio of 3:1, and the ordinary share is priced at $500, the conversion would not be economically viable. This is because investors would be effectively giving up $600 to receive $500.
Understanding the Conversion Premium
One of the foremost important factors that are considered when converting a convertible stock to an ordinary one it’s the conversion premium. It tells us the direct gain to be made at the time of the conversion.
To drive the point home, we illustrate the concept of the conversion premium through a simple example:
Let’s assume a company has issued convertible shares to its investors, with a conversion ratio of 20:1, which means 20 convertibles would deliver a single ordinary share.
If the convertible is trading in the secondary market at $5, and the market price of its ordinary share is $80, we work out the conversion premium as follows:
Market value of convertible stocks:
$5 × 20 = $100
Market value of ordinary stock:
$80
Conversion Premium
$100 – $80 = $20
In the aforementioned example, we see the converting each convertible stock would result in a direct gain of $20 per stock. This would be a major motivation for holders to exercising the conversion of the security.
Conclusion
Convertible shares are great market instruments that act as hybrid investments, which deliver substantial benefit to their holders. They are extremely flexible and could potentially allow investors to profit in moments of prime opportunity.
Due to the inherent nature of these securities, they are great for those seeking to balance income and capital appreciation, while choosing to hold on to the possibility of conversion.
By combining certain aspects of both debt and equity, convertible stocks allow investors a unique way to profit from the growth of the company, while remaining relatively protected from downside risk.
FAQs
When are a company’s only potential common shares its convertible bonds?
A company’s only potential common shares are convertible bonds when no other shares have been issued. This normally happens in the case of startups where the first financiers are debt providers.
How are common shares accounted for in convertible preferred stock security?
Common shares are partially accounted, for as an equity component in the convertible preferred stock security as one portion, whereas the remainder is accounted as a debt component.
How does convertible debt to shares show up on a cash flow statement?
The conversion of convertible debt to shares does not appear on a cash flow statement as it involves no transfer of funds. It is merely a financial conversion that reduces liability and increases equity.
