Financial securities have evolved over time to form certain hybrids, giving rise to convertible securities that have unique benefits for investors and issuers alike. Read on to understand what are convertible securities.
In the world of automobiles, ‘convertible’ usually means a sedan that can be turned into an open-top car. Similarly, in the world of finance, ‘convertible’ stands for a unique type of securities that can change from their initial form to shares of a company. While this may sound confusing right now, the concept is easy to grasp once you understand it. Let’s talk about the types of convertible securities and their features.
What is a convertible security?
In the simplest terms, convertible securities can be bonds or preferred stocks that pay regular interest and can be converted into shares of common stock of the issuing company.
These securities have an option built in at the time of issue that, if exercised, allows them to be converted into common stock.
This may bring up a lot of questions like what types of securities are convertible? Why do companies issue convertible securities at all? How complicated is this conversion? Should you consider investing in convertible securities?
Let’s understand this in detail.
Types of convertible securities
The most common types of convertible securities are convertible bonds and convertible preference shares. Let’s understand them in detail:
- Convertible bonds
A convertible bond is a type of debt security that includes an option to exchange the bond for a predetermined number of shares in the issuing company at a predetermined time. It is a hybrid security that possesses features of both debt and equity.
Similar to regular bonds, a convertible bond comes with a maturity date and pays interest. In addition, if you decide not to convert your bonds to equity, you will receive the bond’s face value at maturity. If you convert the bonds to the company’s shares, the bond will lose all its debt features and then possess only equity features.
But why would a company issue convertible bonds? Mainly because they can offer a lower coupon rate because of the attractive offer to convert to equity for the investors. Another important reason is that it buys the company some time before it is converted to shares and holds off on diluting the shares. The company can thereby save cash at the time of maturity and instead of repaying the face value of the bonds, convert them into equity shares instead.
- Convertible preference shares
Before we go into what convertible preference shares are, let’s first understand preference shares. Preference shareholders, like the name suggests, get preference at the time of dividend before it is paid to common shareholders. Most preference shares usually carry a fixed rate of dividend, and preference shareholders typically do not have voting rights.
Convertible preference shares include the option to convert them to common shares of the company. Convertible preference shares continue to pay fixed dividends before conversion. Once they have been converted to common stock, they participate in the dividend declared by the company and also have full voting rights.
Features of convertible securities
- Conversion ratio: Convertible securities come with a predetermined conversion ratio that determines how many shares will be allotted if the option to convert is exercised at the time of maturity.
- Fixed coupon/dividend: Convertible bonds and convertible preference shares carry a steady return in the form of coupon and fixed dividend, respectively.
Should you consider investing in convertible securities?
The main advantage of convertible securities is that it offers investors a chance to participate in the potentially large returns that come with owning shares while having the security of a bond or preference share with fixed returns.
Getting caught up in all the intricacies of convertible securities can make them look more complex than they really are. Convertibles provide a sort of safety net for investors who wish to participate in the growth story of a company while limiting the downside. However, to make an informed decision, it’s important to understand the risks and have knowledge about the track record of the company.