Convertible Preferred Stock

What is Convertible Preferred Stock?

Convertible preferred stocks are a special class of stocks issued by the company which gives the right to the investor to convert its preferred stock holding into fixed numbers of shares of company common stock after the predetermined time span. Convertibles preferred are hybrid instruments with bond and equity-like features wherein, it is equivalent to bonds with fixed dividend payment plus as the option to acquire common stock.

Example

An investor bought 100 shares of convertible preferred stock in ABC Company @ 500 per share on June 1, 2007. So, the initial investment made by an investor is $50000 (100 shares * $500). It offers a fixed dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price.  It represents the potential return on investment for a given stock.read more of 5%, i.e. $25 per share along with a special conversion right wherein 1 share of preferred stock can be converted into 50 shares of common stock (known as conversion ratio), i.e. if an investor opts for conversion, he will be entitled to 5000 common shares (100 preferred stock * 50 common shares). This right can only be applied after June 1, 2008 (known as the conversion date).

Applying the below formulae can give the total cost per common share after conversion is applied:

Par Value of Convertible Preferred Stock/No. of Common Stock Entitled as a Part of the Conversion.

In this case, it’s $10 (500/50) which is termed as the conversion price.

Case #1

Now let’s assume on June 1, 2008, the stock price is trading @7 per share in the market. If the investor decides to convert his holding into common stock, the total value of his investment will be $35000 (5000 common shares * $7) on that day. This will fetch him a total loss of $15000 after considering his initial investment of $50000.

Case #2

Now let’s assume that the stock price increased to $30. He would definitely exercise his conversion right as he can get the same stock at 10 as compared to the market price of $30. The difference between $30 and $10 is called the conversion premium. Post conversion, the total value of his investment will increase to $150000 from $50000, giving him a net realizable gain of $100000.

Convertible Preferred Stock

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Source: Convertible Preferred Stock (wallstreetmojo.com)

Advantages

Disadvantages

  • The dividend yield on Preferred stock is much lower than other classes of preferred stock due to additional features provided to them, which is conversion right.
  • Convertible preferred stock bear higher risks in the event of default as they will be paid only after repayment of principal and interest to bondholders, i.e. they will be par to other equity shareholders.
  • When conversion feature is exercised, preference shareholder will be treated as other equity shareholder and enjoys no priority in either in dividend and asset distribution.
  • Exercise of convertible options leads to an increase in the number of outstanding shares and creates dilution of control from the perceptive of equity shareholders. Therefore, each shareholder is entitled to a smaller proportion of firm assets and profits. This problem never arises with traded options. If an investor buys an exchange-traded option and subsequently exercises it, there is no effect on the number of shares outstanding.

Key Points to Remember

  • Interest rates affect the pricing of Preference shares. Higher rates make them unattractive, whereas low interest makes them attractive.
  • Just like bonds most convertible shares are rated by large rating organizations such as S&P, Moody and Fitch.
  • When exercising the convertible option, investors must consider whether a higher yield will compensate them with higher risk like equity security.

This has been a guide to What is Convertible Preferred Stock & its Definition. Here we discuss the convertible preferred stock example along with its advantages and disadvantages. You can learn more about from the following articles –

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