Definition
Convertible securities are a type of investment that gives the holder the right to exchange the security for a pre-specified number of another entity’s shares, typically common stock, at any time. These are often issued as corporate bonds or preferred shares that can be converted into common shares. This conversion feature provides potential for upside appreciation if the value of the common shares increases.
Key Takeaways
- Convertible securities are types of investment that can be changed into another form, usually that of common stock.
- They provide investors with the opportunity to benefit from the potential upside of a company’s stock price while still receiving the stable income of a bond.
- The convertible feature often attracts investors as it offers a higher potential return, but it also dilutes the ownership interest and potentially the earnings per share of common stockholders when conversion occurs.
Importance
Convertible securities are important in finance as they offer a way for investors to potentially increase their returns while also providing some downside protection.
They are a type of investment that can be changed into another form, often shares of the company’s common stock.
This allows the investor to benefit from any increase in the company’s stock price.
At the same time, if the stock price declines, the investor still has the asset value of the bond component of the convertible security.
This built-in flexibility makes convertible securities an attractive investment option for many investors and a valuable tool for companies to raise capital.
Explanation
Convertible securities are unique financial instruments primarily used by companies who wish to raise capital with a lower interest burden and potentially less risk. These can be thought of as hybrid securities because they combine the features of both debts and equities.
Essentially, convertible securities give the holders the right, but not the obligation, to exchange these securities for a predetermined number of the issuing company’s common shares. This ability to convert the securities into stock offers an appealing upside potential for investors while providing improved financing flexibility for the issuer.
Commercially, the purpose of convertible securities often revolves around balancing the company’s capital structure and minimizing financing costs. Issuing convertible bonds instead of standard bonds can allow a company to offer a lower coupon rate because of the conversion feature, therefore reducing immediate borrowing costs.
For investors, convertible securities offer an intriguing mix of bond-like income protections with an option for equity-like returns should the company perform well, hence offering a benefit from a risk management perspective. Therefore, these securities play a significant role in corporate financing strategies and investment diversification.
Examples of Convertible Securities
Tesla Convertible Bonds: In 2014, Tesla Inc. issued 5-year and 7-year convertible notes to raise $2 billion. Investors who purchased these notes had the right to convert them into Tesla’s common stock at a certain conversion rate. This allowed Tesla to raise capital in the short term and offered potential upside to the note holders if Tesla’s stock price increased.
Bank of America Corporation Preferred Stock: Bank of America issued a Series L Convertible Preferred Stock that gives the stockholders an option to convert their preferred stock into common stock at their discretion. This offers an opportunity for investors to participate in the company’s equity growth.
Salesforce.com Convertible Senior Notes: In 2013, Salesforce.com issued convertible senior notes due in 2018 with an initial conversion rate of
9316 shares of common stock per $1000 principal amount, which means investors could potentially profit if the price of Salesforce’s stock went up before the note matured.
FAQs on Convertible Securities
What are Convertible Securities?
Convertible Securities are financial instruments, often bonds or preferred shares, that can be converted into a different form, typically into common shares of the same company. They give the holder the right to exchange the security for a specific number of shares.
What are the benefits of investing in Convertible Securities?
Convertible securities can offer the best of both worlds to investors: they provide the potential for capital appreciation if the company’s stock price increases and offer the security of income if the company’s stock price decreases.
What is the conversion price?
The conversion price is the price at which convertible securities can be exchanged for common shares. The conversion price is often set at a premium to the company’s current stock price at the time of issue.
What are Forced Conversion?
Forced conversion occurs when a company requires holders of its convertible securities to convert them into common stock. This usually happens when the company’s share price is significantly higher than the conversion price.
What is the difference between Convertible Bonds and Convertible Preferred Shares?
Convertible bonds and convertible preferred shares are both types of convertible securities, but with slight differences. Convertible bonds are debt instruments that can be converted into common shares of the issuing company. On the other hand, convertible preferred shares are stock that can be converted into common stock. Both offer the potential for capital appreciation while providing income security, but they have different risk and reward profiles.
Related Entrepreneurship Terms
- Equity Conversion
- Bond value
- Call Provision
- Conversion Ratio
- Conversion Premium
Sources for More Information
- Investopedia: This website provides a vast amount of investing and financial information, including articles, financial dictionary, news, tutorials, etc.
- MarketWatch: MarketWatch provides real-time financial information, news, insights, and analysis, including detailed information on various financial products like convertible securities.
- Morningstar: This website offers comprehensive data and analysis on thousands of stocks and bonds, including convertible securities.
- Seeking Alpha: Seeking Alpha delivers a broad range of financial information, with various articles, blogs, and news on a wide array of financial products and terms.
