What Are Convertible Preferred Shares?
Buying stocks always creates the risk of losing money, but avoiding them altogether in favor of safer investments means missing out on the opportunity for the best profits. There is one type of security, however, that may solve this dilemma for some investors: convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation.
Convertible preferred shares are fixed-income securities. The investor can choose to trade this type of share for a certain number of shares of the company's common stock, either after a predetermined length of time or on a specific date.
Key Takeaways
- Convertible preferred shares can be converted into common stock at a fixed conversion ratio.
- If the market price of the company's common stock rises above the conversion price, the preferred shareholders can convert those shares to common stock.
- With the conversion, the shareholder gives up the rights of a preferred shareholder.
Understanding Convertible Preferred Shares
Convertible preferred shares do not fluctuate in price with the market. Like bonds, they pay a predetermined return that is set at the time of their purchase. Unlike with bonds, however, the investor can choose to exchange them for shares of the company's common stock after a preset length of time,
This creates two benefits to investors:
- The fixed-income component offers a steady income stream and some protection of the invested capital.
- The option to convert these securities into stock allows the investor to gain from a rise in the share price.
Convertibles are particularly attractive to investors who want to participate in the rise of hot growth companies while being insulated from a big price drop should the stocks not live up to expectations. From the viewpoint of the companies that issue them, convertible preferred shares are a way to raise money that may be easier and quicker than going through a conventional lending institution.
How Convertible Preferred Shares Benefit Investors
Let's say Company XYZ issues one million convertible preferred shares priced at $100 per share. These convertible preferred shares give the holders priority over common shareholders in two ways.
- Convertible preferred shareholders receive a 4.5% dividend (provided XYZ's earnings continue to be sufficient) before any dividend is paid to common shareholders.
- Convertible preferred shareholders will rank ahead of common shareholders if XYZ ever goes bankrupt and its assets have to be sold off.
By buying XYZ convertible preferred shares, the investor will receive a $4.50 annual dividend for each share. But there is the possibility of higher returns. If XYZ's shares rise in value, they can turn their fixed-income investment into an equity investment. On the reset date, shareholders of XYZ convertible preferred shares may convert some or all of their preferred shares to common stock.
Drawbacks
The Securities and Exchange Commission warns investors that convertible shares may depress the value of common shares by diluting them. Another drawback is that convertible preferred shareholders, unlike common shareholders, rarely have voting rights.
How the Conversion Ratio Works
The conversion ratio represents the number of common shares that shareholders may receive for every convertible preferred share. The conversion ratio is set by management before the issue, typically with guidance from an investment bank.
For XYZ, let's say the conversion ratio is 6.5, which allows investors to trade in the preferred shares for 6.5 shares of XYZ stock.
The conversion ratio shows what price the common stock needs to be trading at for the shareholder of the preferred shares to make money on the conversion. This price, known as the conversion price, is equal to the purchase price of the preferred share, divided by the conversion ratio. So for XYZ, the market conversion price is $15.38 or ($100/6.5).
In other words, XYZ common shares need to be trading above $15.38 for investors to gain from a conversion. If the shares do convert and drop below $15.38, the investors will suffer a capital loss on their $100-per-share investment. If common shares finish at $10, for instance, then convertible preferred shareholders receive only $65 ($10 x 6.5) worth of common shares in exchange for their $100 preferred shares. (The $100 represents the parity value of the preferred shares.)
Understanding the Conversion Premium
Convertible preferred shares can be sold on the secondary market. The market price and behavior are determined by the conversion premium, which is the difference between the parity value and the value of the preferred shares if the shares were converted. As shown in the example above, the value of the converted preferred share is equal to the market price of common shares multiplied by the conversion ratio.
Let's say XYZ's stock currently trades at $12, which means the value of a preferred share is $78 ($12 x 6.5). As you can see, this is well below the parity value. So, if XYZ's stock is trading at $12, the conversion premium is 22% or [($100 - $78)/100].
The lower the premium, the more likely the convertible's market price will follow the common stock value up and down. Higher-premium convertibles act more like bonds since it's less likely that there will be a chance for a profitable conversion. That means that interest rates, too, can impact the value of convertible preferred shares.
Like the price of bonds, the price of convertible preferred shares will normally fall as interest rates go up since the fixed dividend looks less attractive than the rising interest rates. As rates fall, convertible preferred shares become more attractive.
Are Convertible Preferred Shares a Hybrid Investment?
Essentially, yes. Convertible preferred shares act like a bond unless and until the shareholder swaps them for common stock shares in the same company.
Convertible preferred shares come with a set guaranteed return on the investment. That's very bond-like. However, if the company's common shares rise above a certain level after a certain date, the preferred shareholder can swap the shares for common stock. The shareholder will immediately realize a profit while giving up the certainty of the return.
Are There Convertible Share ETFs?
Yes, there are a number of exchange-traded funds (ETFs) that invest in preferred shares. Big names in this business include iShares, First Trust, Invesco, and SPDR.
Are Convertibles a Good Investment?
Convertible shares can be a good choice for an investor who wants the safety of a guaranteed return plus the potential for a greater return down the road. They can be a good way to invest some money in the stock market while keeping your overall risk low. But like any investment, they aren't the right choice for all investors.
The Bottom Line
Convertible preferred shares appeal to investors who want to participate in the stock market without risking great losses. These securities can be traded, like stocks, when the price of common shares moves above the conversion price. If the stock price slips below the conversion price, the convertible trades just like a bond, effectively putting a price floor under the investment.
