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 Convertibles?

In finance, there’s a class of investment instruments that possess a unique and intriguing characteristic: convertibility.

From convertible bonds to convertible shares, these financial instruments offer investors a fascinating blend of features that combine the best of both worlds.

When we talk about convertible securities, we’re referring to something that possesses the ability to transform or convert into another form of security.

While convertible bonds are well-known, it’s time to shine the spotlight on convertible shares – a fascinating avenue worth exploring.

Convertible shares, as the name suggests, are shares of a company’s stock that have the potential to convert into a predetermined number of common shares at a specified conversion price.

Essentially, they possess the combined characteristics of both debt and equity, making them a hybrid instrument in the world of investments.

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:

• 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.

• 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.

Types of Convertible Bonds

When it comes to investing in convertible shares, it’s important to understand the various types of convertible bonds available in the market.

So, let’s dive into the world of convertible bonds and explore the different flavors you might encounter on your investment journey.

• Traditional Convertible Bonds

  These classic bonds offer fixed interest and a conversion option into company shares, striking a balance between stability and growth potential.

  You’ll enjoy regular interest payments while potentially benefiting from the company’s success.

• Mandatory Convertible Bonds

  With a “must-convert” clause, these bonds automatically convert into shares on a specific date, allowing you to secure fixed income while capturing the potential upside in the stock’s price.

  It’s a confident move by companies to raise capital and reward investors.

• Contingent Convertible Bonds

  Also known as “CoCo bonds,” they offer a unique blend of stability and growth by triggering conversion based on specific events like stock prices or financial distress.

  While carrying some risks, they can be intriguing for those seeking equity-like returns.

• Synthetic Convertible Bonds

  These hybrid instruments combine the features of traditional convertible bonds with options or derivatives, offering increased flexibility to tailor investments.

  While more complex, they allow astute investors to customize risk-return preferences based on their needs and goals.

Example Convertible Calculation

The best way to grasp and contextualize any idea, especially within the realm of finance, is by means of a straightforward example.

Imagine you’re considering investing in a company called Company X, which has just issued convertible shares.

These shares can be converted into common shares at a predetermined conversion price.

Let’s say Company X’s convertible shares have a conversion price of $10 per share, and you decide to invest $10,000 in these convertible shares.

With this information, we can calculate how many common shares you would receive upon conversion.

To calculate the number of common shares, divide your investment amount by the conversion price.

In this case, $10,000 divided by $10 gives us 1,000 convertible shares.

So, if you decide to convert your convertible shares into common shares, you would receive 1,000 shares of Company X.

Now, let’s take it a step further. Suppose the current market price of Company X ‘s common shares is $15 per share.

If you were to convert your convertible shares at this moment, you would receive 1,000 common shares worth $15 each.

So, your initial investment of $10,000 would transform into $15,000 worth of common shares, which you can easily collect due to the high liquidity of shares.

Advantages of a Convertible Note Investment

Now that we understand what convertible shares are, let’s explore the advantages they offer. Investing in convertible shares can be an appealing option for several reasons.

• Simplicity of Documentation

  Investing in convertible shares comes with the perk of simple paperwork.

  Unlike some other investments, the documentation involved is straightforward, making it easier for both you as an investor and the company to navigate the process.

• Delayed Valuation

  With convertible shares, the company has the flexibility to delay its valuation.

  This means that in the early stages when valuing a startup can be tricky, the focus can be on building a strong foundation and proving its worth.

  As an investor, this opens up potential upside as the company grows.

• Easy Way to Raise Large Amounts of Money

  Convertible notes offer a relatively simple and efficient method for companies to raise substantial capital.

  By offering convertible shares, a company can attract investors who are eager to support its growth while deferring the determination of share price until a future financing round.

  As a mode of borrowing cash, this flexibility is appealing to both entrepreneurs and investors, streamlining the process of securing significant funding for ambitious ventures.

Drawbacks of Convertible Notes

Now that we’ve explored the benefits of convertible shares, it’s important to understand the potential drawbacks as well. Let’s dive into two key points:

• Failure of Repayment

  There is a risk that the issuing company may struggle to repay the convertible notes, which could lead to delays or the loss of your investment.

  It’s important to assess the company’s fundamentals before considering such an investment.

• Heavy Debt

  Convertible notes come with an interest rate, and if the company doesn’t achieve expected growth, it may face a significant debt burden, affecting its financial flexibility and other obligations.

  It is important to evaluate the company’s overall debt levels and how convertible notes fit into its capital structure.

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:

• 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.

• 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.

• 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:

• 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.

• 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 in terms of equity return.

• 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.

• 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.

• 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.

• 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.

Convertible Preferred Stock Terms

One seemingly complex area is that of the convertible preferred stock. To grasp this, it is essential to equip ourselves with some specific convertible share terminology.

Understanding these terms will not only help you navigate the intricacies of this investment option but also make informed decisions.

• Par Value

  Par value is basically the face value assigned to each share of convertible preferred stock upon its issuance.

  It’s important to know the par value because it affects the financial calculations associated with the stock.

• Conversion Ratio

  The conversion ratio tells you many common shares you’ll receive in exchange for each convertible preferred stock you own.

  The precise ratio lays out how much you would give away, and how much you would receive upon conversion.

• Conversion Price

  The conversion price is what you pay to turn your convertible preferred stock into common shares.

  It’s the predetermined price at which you can make the conversion.

• Conversion Premium

  This refers to the extra value you might receive when converting your convertible preferred stock into common shares.

  It’s the profit you get in terms of value for holding the convertible.

How Does a Convertible Preferred Share Differ from a Regular Preferred Share?

Now that you are equipped to assess convertible preferred shares, you may wonder, how do they differ from regular preferred shares. Well, let’s break it down in simple terms.

Convertible preferred have a unique feature that regular preferred shares don’t possess – the ability to transform into common shares.

Here’s how it works: If the company’s stock price reaches a predetermined level, the holder of convertible preferred shares can choose to convert them into common shares.

This can be a great advantage if the company performs well and its stock price skyrockets. In ideal conditions, its holders would get to ride the wave of success.

Regular preferred shares, on the other hand, don’t have this conversion option.

They offer a fixed dividend rate and priority over common shareholders when it comes to receiving payouts, but no convertibility, thus leaving out a gains premium.

How Does a Convertible Preferred Share Differ from a Convertible Bond?

In the convertible share space, you might also stumble upon another interesting investment instrument called “convertible bonds.”

Just like there is a distinction between bonds and stocks, there is also a difference between convertible preferred shares and convertible bonds.

Convertible preferred shares and convertible bonds share a common characteristic – the possibility of conversion. However, they differ in their underlying nature.

Convertible preferred shares are a type of equity investment. They represent ownership in a company, entitling you to certain benefits, such as voting rights and potential dividends.

If the company’s stock price reaches a predetermined level, you have the option to convert your preferred shares into common shares.

On the other hand, convertible bonds are debt instruments. They are essentially loans made to a company, with the promise of periodic interest payments.

The unique feature is that, at a future date or under specific conditions, you have the choice to convert these bonds into company shares.

At the end of the day, when choosing between the two, it all comes down to your investment goals and risk tolerance.

Why Would Investors Buy Convertible Preferred Stock?

Investors are drawn to convertible preferred stock for a few good reasons.

Firstly, it offers the best of both worlds. With these shares, you get a fixed dividend payment, just like regular preferred stock, providing a steady income stream.

Moreover, these shares also come with the exciting option to convert them into common shares if the company’s stock price soars.

This flexibility gives investors the opportunity to participate in the company’s success while still having some downside protection.

If the company doesn’t perform as expected, you still have your preferred stock with its fixed dividends.

How Does the Conversion Ratio Work?

The conversion ratio is an essential part of the convertible security setup. 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 stocks 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 stocks 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 stocks 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 the ordinary stock:

$80

Conversion Premium

$100 – $80 = $20

In the aforementioned example, we see that converting each convertible stock would result in a direct gain of $20 per stock. This would be a major motivation for holders to exercise the conversion of security.

Conclusion

Convertible shares are great market instruments that act as hybrid investments, which deliver substantial benefits 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 preferred convertible stocks 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.