What Is A Convertible Security?

A convertible security is a financial instrument that can be converted into another form, typically common stock, at a predetermined price or date. This is commonly found in two types: convertible bonds and convertible preferred stock. Convertible securities combine features of both debt and equity, providing the investor with the opportunity to participate in the company’s growth while receiving regular interest or dividend payments.

Preferred Stock

Preferred stock is a type of equity security that has characteristics of both common stock and bonds. Preferred stockholders have a higher claim on a company’s assets and earnings than common stockholders, but they typically do not have voting rights. Preferred stock pays fixed dividends, which can be cumulative or non-cumulative. Convertible preferred stock allows the holder to convert their shares into a predetermined number of common shares at a specific price, typically after a certain date.

Bonds

A bond is a debt security issued by a company, government, or other entity to raise capital. Bondholders are essentially lending money to the issuer in exchange for interest payments and the return of principal upon maturity. Convertible bonds are a type of corporate bond that can be converted into common stock at the bondholder’s discretion, usually at a predetermined conversion ratio and price.

Pros for Issuing Companies:

  1. Lower Cost of Capital: Companies can often issue convertible securities at a lower interest rate or dividend yield compared to non-convertible debt or preferred stock, as investors are willing to accept a lower yield in exchange for the conversion option.
  2. Flexibility: Issuing convertible securities provides companies with greater financial flexibility, as they can raise capital without immediately diluting existing shareholders’ ownership.
  3. Attracting Investors: Convertible securities can be an attractive option for investors who seek income with the potential for capital appreciation, which may help companies broaden their investor base.

Cons for Issuing Companies:

  1. Potential Dilution: If a large number of convertible securities are converted into common stock, the issuing company may experience dilution in earnings per share, which can negatively impact the stock price.
  2. Higher Debt Burden: Issuing convertible bonds increases a company’s debt burden, which may raise concerns among investors about the company’s financial stability and ability to meet its obligations.
  3. Complexity: Managing convertible securities can be complex for issuing companies, as they need to consider the potential impacts of conversion on their capital structure and financial ratios.

Impact on Stock Price

The issuance of convertible securities can influence a company’s stock price in various ways, depending on factors like market conditions, company performance, and investor sentiment.

Price Increase: Convertible securities can potentially drive a stock price up in several ways:

  1. Anticipation of Conversion: If investors expect the convertible security to be converted into common stock, they may purchase the underlying shares in anticipation, driving up the stock price.
  2. Positive Signal: Issuing convertible securities can be perceived as a positive signal by the market, indicating that the company is confident in its growth prospects and its ability to repay the debt or dividends associated with the convertible security.
  3. Favorable News: Companies may release favorable news or financial results to drive up the stock price before announcing a convertible security, making it more attractive to investors.

Price Decrease: Convertible securities can also lead to a decrease in stock price, as they can:

  1. Dilute Ownership: The conversion of convertible securities into common stock increases the number of outstanding shares, diluting existing shareholders’ ownership and potentially causing a drop in the stock price.
  2. Higher Debt Burden: Issuing convertible bonds increases a company’s debt burden, which may raise concerns among investors about the company’s ability to meet its financial obligations, causing the stock price to decline.

Real-life Examples

Price Increase: In June 2020, Tesla Inc. announced plans to issue $1 billion in convertible senior notes due in 2025. The announcement coincided with an increase in Tesla’s stock price, as investors anticipated future growth and higher demand for electric vehicles.

Price Decrease: In August 2017, Pandora Media Inc. announced the issuance of $300 million in convertible senior notes due in 2023. The stock price dropped as investors worried about the company’s increased debt burden and the potential dilution of existing shareholders’ ownership.