Convertibles: Definition, Types, and How They Work

What Are Convertibles?

Convertibles are securities, usually bonds or preferred shares, that can be converted into common stock. Convertibles are most often associated with convertible bonds, which allow bondholders to convert their creditor position to that of an equity holder at an agreed-upon price. Other convertible securities can include notes and preferred shares, which can possess many different traits.

Understanding Convertibles

Convertibles are ideal for investors demanding greater potential for appreciation than bonds provide, and higher income than common stocks offer. Convertible bonds, for instance, typically offer a lower coupon than a standard bond. However, the optionality of the bond to convert to common stock adds value for the bondholder.

There are three main types of investments: debt, equity, and some hybrid form of the two. Convertible securities fall into the hybrid category because they have cash flow features of both a bond and a stock.

Like other bonds, convertible bonds are considered debt. In exchange for the use of investor funds, the company agrees to pay the investor a set rate of interest referred to as the coupon rate. Unlike other bonds, convertibles also give the holder the right to convert the bond into shares of stock.

Investors like convertibles because they offer protection against heavy losses, but they also give up some value in appreciation. Most convertible bonds are callable, which means the company can force investors to convert. In this case, the upside potential of convertibles is not unlimited.

Types of Convertible Bonds

A vanilla convertible bond, perhaps the least complicated convertible, provides the investor with the choice to hold the bond until maturity or convert it to stock. If the stock price has decreased since the bond's issue date, the investor can hold the bond until maturity and get paid the face value. If the stock price increases significantly, the investor can convert the bond to stock and either hold or sell the stock at their discretion. 

On the other hand, mandatory convertible bonds are required to be converted by the investor at a particular conversion ratio and price level. Furthermore, a reversible convertible bond gives the company the right to convert the bond to equity shares or keep the bond as a fixed-income investment until maturity. If the bond is converted, it is done so at a preset price and conversion ratio.

A company might also issue debt using convertible bonds that convert at a fixed dollar value that is paid in shares. During a price decline, the holders of these bonds are motivated to convert because they will receive more shares at a lower price.

Types of Convertible Equities

Convertible stock is a financial instrument that combines characteristics of both stocks and bonds. Essentially, convertible stock is a type of preferred stock that can be converted into a predetermined number of common shares. This feature provides investors with the opportunity to benefit from potential increases in the issuer's stock price while still enjoying the stability and income associated with preferred stock.

Convertible stock offers investors a combination of potential capital appreciation and income generation. By holding convertible stock, investors have the flexibility to benefit from increases in the issuer's stock price while still receiving regular dividend payments. Preferred equities receive preferential treatment when it comes to dividend distributions, so investors can prioritize hanging onto preferred stock if that’s their top priority.

We’ll talk more about why issuers might want to release convertible securities later. For now, it’s worth mentioning convertible stock can provide issuers with a cost-effective way to raise capital, as it allows them to issue securities with lower coupon rates than traditional bonds. 

Common Features of Convertible Securities

There's a couple of things that set convertibles apart from traditional stocks and bonds. Note that a single security may not have all of these features; be mindful to investigate the specific convertible securities you’re interested in as it may not contain some of these features. 

• Conversion Option: It should go without saying at this point, but convertible securities grant the holder the right to convert the security into a predetermined number of common shares of the issuer's stock.
• Call Provision: Some convertible securities may include a call provision that allows the issuer to redeem the securities at a predetermined price before maturity, providing flexibility to manage debt obligations. A call provision is the company’s ability to convert the security. 
• Maturity Date: For convertible bonds, this is the date on which the issuer is obligated to repay the principal amount to investors, unless the bond is converted into common stock before maturity. This is the last date before the security is paid off and ceases to exist.
• Dividends: Convertible preferred stocks may pay dividends to investors, providing a regular income stream. Dividends may be cumulative, meaning unpaid dividends accrue and must be paid before common shareholders receive dividends.
• Priority in Liquidation: Convertible preferred stocks may have priority over common stocks in the event of liquidation, entitling holders to receive their investment back before common shareholders. This is one of the more primary reasons why people may not want to convert their security. 
• Conversion Trigger: Certain convertible securities may have conversion triggers tied to specific events, such as the issuer's stock price reaching a certain threshold or the passage of a certain amount of time. Conversion triggers are discussed in more depth later in this article. 
• Voting Rights: Convertible securities typically do not carry voting rights, as they are considered debt or preferred equity instruments rather than common equity. 

Advantages of Convertible Securities

Investing in convertible securities offers a number of advantages. First, convertible securities provide a unique blend of upside potential and downside protection. As a hybrid instrument, they offer the opportunity to participate in the potential appreciation of the underlying equity while providing a cushion of fixed-income characteristics. This duality can be particularly appealing in volatile markets, where the stability of fixed income combined with the potential for equity-like returns can help manage risk effectively. Note that this feature is prevalent in converting from a bond to stock item and is less relevant when converting from one type of equity to another. 

Convertible securities can serve as a diversification tool. By combining attributes of both stocks and bonds, they can help spread risk across asset classes and sectors. This diversification can be particularly valuable during market downturns, as convertible securities may exhibit lower correlation with traditional stocks and bonds. Instead of having to sell a security and repurchase another at an unknown conversion rate, an investor can pre-plan its portfolio allocation based on how much of they will receive after a conversion. 

Investors may also get a greater ability to get exposure to specific industries or companies that they believe have strong growth potential. A company may choose to only issue a convertible security, meaning an investor has to buy a fixed-income security before it is able to convert that to a common equity security. 

Lastly, convertible securities can offer strategic opportunities for issuers and investors alike. For investors, they may choose to trigger when to convert the security depending on if certain market conditions present themselves. Otherwise, they may choose to never convert the security because that may strategically make the most sense. In either case, the investor has the greatest amount of flexibility because of the added convertibility of the security. 

Tax Implications of Convertible Securities

There's some tax rules to keep in mind about convertibles. Interest income from convertible bonds is typically taxed at ordinary income tax rates, while dividends from convertible preferred stocks may qualify for preferential tax treatment such as qualified dividend tax rates. 

Second, investors should consider the tax consequences of capital gains or losses realized from owning convertible securities. When convertible securities are sold or converted into common stock, any resulting capital gains or losses are subject to capital gains tax treatment. The holding period of the convertible security determines whether capital gains are taxed at short-term or long-term capital gains rates. Short-term capital gains are taxed at ordinary income tax rates, while long-term capital gains are typically taxed at lower rates, providing potential tax advantages for investors who hold convertible securities for more than one year.

Investors should also be mindful of the tax implications of bond premiums and discounts associated with convertible bonds. Bond premiums, which occur when the purchase price exceeds the face value of the bond, may need to be amortized over the remaining term of the bond and reported as taxable interest income each year. Conversely, bond discounts, which occur when the purchase price is below the face value of the bond, may result in taxable capital gains if the bond is sold or redeemed at a gain before maturity. 

Last, investors should consider the impact of tax-efficient strategies, such as tax-loss harvesting and tax-deferred accounts. Tax-loss harvesting involves selling investments at a loss to offset capital gains and reduce tax liabilities. Though a convertible security has different avenues of treatment, one additional means of treatment is to sell at a loss for tax reasons.

One other related but unrelated tax point to make involves investing in convertible securities within tax-deferred accounts such as individual retirement accounts (IRAs) or 401(k) plans. Holding securities in these types of accounts can defer taxes on investment gains until distributions are taken in retirement. Note that there may be restrictions on when you can withdraw original funds or appreciated dollars in exchange for this tax benefit. 

Risks and Downsides to Convertible Securities

There are also risks and downsides associated with convertible securities. First, the conversion option embedded in these securities can act as a double-edged sword. If the underlying stock price fails to appreciate sufficiently, investors may miss out on potential gains compared to holding common stock outright. Conversely, if the stock price declines significantly, the convertible security may lose value, as the conversion feature becomes less attractive. In some cases, it might’ve just been better to have bought the common stock instead of electing to buy convertible debt. 

Secondly, convertible securities are subject to interest rate risk. Like traditional bonds, convertible bonds are sensitive to changes in interest rates. This means that when interest rates rise, the value of fixed-income securities tends to decline. This can result in capital losses for investors who need to sell their securities before maturity. If an investor doesn’t think they’ll actually elect to convert, they need to be aware that the value of their fixed-income security may actually lose value over time as well. 

Another risk associated with convertible securities is related to credit risk. While convertible bonds may offer the potential for capital appreciation through their equity component, they still carry the credit risk associated with the issuer. If the issuer experiences financial distress or defaults, investors in convertible bonds may face losses. This may include the fact that the issuing company may not be able to pay back its debt. Alternatively, the issuer’s common shareholders may not have a priority to company net assets upon liquidation, so a holder of a convertible bond may be in an unfavorable position either way. 

Lastly, liquidity risk can be a concern for investors in convertible securities. Convertible securities may have lower trading volumes compared to common stocks or traditional bonds, making it more challenging to buy or sell them at desired prices. This lack of liquidity can result in wider bid-ask spreads and increased transaction costs. This means it may just take a little longer or be slightly more expensive to trade a convertible security (at least for securities that are in very illiquid markets). 

Who Typically Issues Convertible Securities, and Why?

Convertible securities are commonly issued by a diverse range of companies Growth-oriented often issue convertible securities to raise capital for expansion, research and development, or acquisitions. These companies may prefer convertible bonds or preferred stocks over traditional equity offerings to minimize immediate dilution to existing shareholders. Those initial, existing shareholders likely want to preserve the proportion of the company they own, yet the company still may need more money for growth. 

On the other end of the spectrum, distressed or highly leveraged companies may opt for convertible. Convertible bonds may offer these companies a way to access financing at lower interest rates compared to traditional bonds, as investors are willing to accept lower coupon rates in exchange for the conversion feature. By raising funds this way, distressed companies can improve their liquidity position and reduce the risk of default while providing investors with the potential for a possible lucrative equity participation in the event of a turnaround.

Furthermore, companies in cyclical industries or undergoing significant business transformations may utilize convertible securities as a flexible financing tool. Convertible securities offer these companies the ability to adapt to changing market conditions since their company may not operate the exact same throughout the entire year. This allows issuers to raise capital during periods of uncertainty or transition while preserving financial flexibility and avoiding long-term commitments associated with traditional financing methods.

Lastly, private equity-backed or venture capital-funded companies may issue convertible securities as part of their capital structure to align incentives between investors and management. Convertible securities provide a mechanism for investors to participate in the company's growth potential while providing downside protection in the form of fixed-income characteristics. In certain ways, a convertible security is a safer way to provide certain people a reward or incentive to be engaged with the company as debt instruments may have better protection compared to equity instruments. 

Convertible Securities and Trigger Events

Convertible securities may incorporate conversion triggers to initiate the conversion process under specific circumstances. These triggers can vary widely depending on the terms and conditions set forth in the security's prospectus. 

One common conversion trigger is tied to the issuer's stock price reaching a predetermined threshold. For example, the convertible security may specify that if the issuer's stock price remains above a certain level for a specified period, the security will automatically convert into a predetermined number of common shares. This threshold is often set at a premium to the prevailing market price to ensure that conversion occurs only when the stock price has demonstrated sustained strength.

Alternatively, convertible securities may feature conversion triggers based on the passage of time. For example, the security may stipulate that it will convert into common shares after a certain number of years, regardless of the issuer's stock price. Time-based triggers can align with the issuer's long-term strategic objectives and provide clarity for investors regarding the timing of potential conversion events.

Some convertible securities may incorporate conversion triggers linked to specific corporate events or milestones. For example, the security may specify that conversion will occur if the issuer announces a merger, acquisition, or spin-off that meets certain criteria. This type of trigger aims to capture value for investors in the event of corporate actions that are expected to enhance shareholder value. It may also act as a way for an investor to re-consider their investment strategy with the company based on prevailing events.

Note that another common trigger is simply at the election of the investor. A convertible security may not have any trigger terms mentioned above. However, an investor may simply make the election when they choose, regardless of the timing, prevailing events, or market price of the stock. 

Convertible Securities and Conversion Rates

Convertible conversion rates are usually determined at the time of issuance and are specified in the terms of the convertible security. The conversion rate establishes the number of common shares that the investor will receive upon converting one unit of the convertible security. This rate is calculated based on the predetermined conversion price and is designed to provide investors with a fair exchange ratio between the convertible security and the issuer's common stock.

The conversion rate is determined by dividing the face value or par value of the convertible security by the conversion price. For convertible bonds, the face value represents the principal amount of the bond, while for convertible preferred stocks, it represents the liquidation preference or stated value per share. The conversion price is the price at which the convertible security can be converted into common shares, usually set at a premium to the current market price of the common stock.

For example, if a convertible bond with a face value of $1,000 has a conversion price of $50 per share, the conversion rate would be 20 shares ($1,000 / $50 = 20). This means that the investor would receive 20 common shares for each convertible bond converted. Similarly, if a convertible preferred stock with a liquidation preference of $100 has a conversion price of $10 per share, the conversion rate would be 10 shares ($100 / $10 = 10).

The main takeaway here is that the conversion rate is fixed at the time of issuance and remains constant throughout the life of the convertible security. However, the conversion price may be subject to adjustments under certain circumstances such as stock splits, stock dividends, or corporate actions that affect the value of the common shares. You should be aware not only of the fact that your security has the feature to be converted but also what that security will convert to. This rate should always be accessible and published somewhere, even if it is subject to change. 

Convertible Security and Conversion Rate Alternatives

In the example above, we looked at a fixed conversion rate where the amount of share issued was a fixed amount based on the face value of both of the securities. There are other conversion rates as well you may come across for convertible securities, though. Below is not an exhaustive list:

• Floating Conversion Rate: The conversion rate is not fixed at issuance but is determined based on a formula tied to the market price of the underlying common stock at the time of conversion. This allows for adjustments to the conversion rate to reflect changes in the market value of the stock. However, this may result in an investor getting less shares than they thought based on changes in market value. 
• Adjustable Conversion Rate: The conversion rate may be subject to adjustments based on certain predetermined events such as stock splits, stock dividends, or rights offerings. These adjustments ensure that the conversion rate maintains its proportional relationship with changes in the issuer's capital structure. This rate usually aims to convert shares at a proportional rate as to not dilute anyone’s potential equity holding from before.
• Step-Up Conversion Rate: The conversion rate may increase over time at predetermined intervals or based on specific milestones. This gradual increase incentivizes investors to hold the convertible security for longer periods by offering a higher conversion rate in the future.
• Reverse Conversion Rate: The conversion rate may be based on the number of common shares that can be acquired for each unit of the convertible security, rather than the other way around. This approach is less common but can be used in certain structured products or derivative securities.
• Market-Linked Conversion Rate: The conversion rate may be tied to the performance of an external benchmark, such as a stock index, commodity price, or currency exchange rate. This provides investors with exposure to specific market factors, adding in some undesired risk and uncertainty to the conversion process.
• Negotiated Conversion Rate: In private placements or customized convertible securities, the conversion rate may be negotiated between the issuer and the investor. This allows for greater flexibility in structuring the terms of the convertible security to meet the needs of both parties, and the conversion rate does not need to be the same for every private investor. 

Example of Convertible Calculation

In this simple example, a convertible bond has a par value of $1,000 and a selling price of $800. The shares of this company are selling for $40. The share price at which the convertibility feature becomes profitable is calculated by dividing $800 by 30, the conversion rate. The answer is $26.67, which is much less than $40. An investor can decide to convert and take profit at this point. If the bond never becomes profitable, the holder receives the bond’s stated interest rate.

The Bottom Line

Convertible securities are financial instruments, typically bonds or preferred stocks, that can be converted into a predetermined number of common shares of the issuing company. They offer investors the potential for capital appreciation through conversion into equity, though you don't necessarily have to do the conversion if you don't want to.