Convertible Security: Definition, How It Works, Example

What Is a Convertible Security?

A convertible security is an investment that can be changed from its initial form into another form. The most common types of convertible securities are convertible bonds and convertible preferred shares, which can be converted into common stock.

A convertible security specifies the qualifying terms and price at which it can be converted, and pays a periodic fixed amount (a coupon payment for convertible bonds and a preferred dividend for convertible preferred shares).

How a Convertible Security Works

Convertible securities usually have a lower payout than comparable securities that do not have the conversion feature. Investors are willing to accept the lower payout due to the potential profit from sharing in the appreciation of a company's common stock through the conversion feature.

The conversion value is similar to the value of the call option on the common stock. The conversion price, which is the preset price at which the security can be converted into common stock, is usually set at a price higher than the stock's current price. If the conversion price is closer to the market price, then it has a higher call value. The underlying security is valued based on its par value and coupon rate. The two values are added together for a more complete picture of the security's valuation.

The price of the underlying common stock heavily influences the performance of a convertible security. The degree of correlation increases as the stock price approaches or exceeds the conversion price. Conversely, if the stock price is far below the conversion price, the security is likely to trade as a straight bond or preferred share, since the prospects of conversion are viewed as remote.

Special Considerations

Companies will issue convertible bonds to lower the coupon rate on debt. Because of the conversion feature, investors will accept a lower coupon rate on a convertible bond. This helps the company issuing the bond save on interest expenses.

Companies will also issue convertible bonds to delay dilution. Dilution occurs when a company issues new stock which then results in the decrease of the ownership percentage for existing shareholders. Instead, the company may decide to raise needed capital through issuing convertible bonds rather than diluting the equity position of shareholders already holding the stock.

Sometimes, however, the company issuing the securities wants to be in a position to force the investor's hand. The company does this by adding a call feature that allows it to redeem the bonds based on criteria set at issuance. A common example is to make the bonds callable at or near the conversion price. The company eliminates interest expense while the investor receives either return of capital or common stock equal to the initial investment.

Example of a Convertible Security 

A company with a current common stock price of $5 per share wants to raise some additional capital through a 10-year bond offering. Based on the company's credit rating, the interest rate is set at 8%. The company determines that the interest rate can be reduced to 6% by adding a conversion option at $10 per share. On a $1 million convertible bond offering, the company saves $20,000 per year in interest.

A $1 million investor in the convertible bond receives total interest payments of $600,000 ($60,000 per year times 10 years) instead of the $800,000 payable on a nonconvertible bond. However, if the stock rises to $12, the investor would convert their bond to common stock valued at $10, making an additional $200,000 as a capital gain. Any increase in the stock price above $12 results in additional profit. The investor has the flexibility to take additional profits based on market valuation at any time during the bond's 10-year life span.