Convertible security definition

/

What is a Convertible Security?

A convertible security is a bond, preferred stock, or a similar financial instrument that can be converted into the common stock of the issuing entity. When an investor elects to convert a security into common stock, this results in the elimination of the fixed stream of payments associated with the original investment and replaces it with stock that does not have such a related payment stream. Consequently, the only realistic inducement for an investor to trigger the conversion is when the market price of the common stock is so high that an immediate profit can be realized by selling the shares on the open market.

Related AccountingTools Courses

Corporate Cash Management

Corporate Finance

Investing Guidebook

Understanding Convertible Securities

Investors want the option to convert into common stock, so they are usually willing to accept a lower rate of return on the interest payments being made to them on the original convertible security. A large price discount means that investors believe there is an opportunity to earn a substantial return on the underlying conversion feature.

The conversion feature is usually only made available to investors at a higher price than the market price of the issuer’s common stock when the convertible security was originally issued. The value of the underlying call option increases as the market price of the common stock approaches the conversion price. Conversely, the value of the call option declines as the market price of the common stock drops below the conversion price. The call option value may be essentially irrelevant if the market price of the common stock is well below the conversion price.

Advantages of Convertible Securities

There are several advantages when a business issues convertible securities. They are as follows:

  • Cap on the maximum payout. The issuer can initially limit payments to a fixed periodic amount until investors decide to convert the securities into stock. This is useful, since it puts a cap on the maximum payout.

  • Deferred dilution. The current shareholders in the business are not having their ownership interests diluted until the convertible security holders decide to convert their holdings into shares - which may never happen.

  • No voting rights. The holders of convertible securities have no voting rights, so they have no say in the direction of the business.

  • Reduced interest rate. Investors are usually willing to take an interest rate cut in exchange for the conversion privilege, which reduces the financing costs of the issuer.

  • Tax deductibility of interest. The interest initially being paid on these securities is tax-deductible for the issuer, which reduces its borrowing costs.

  • Attracts more investors. Convertible securities can attract both fixed-income investors (because of the bond features) and equity investors (due to the equity conversion potential). This increases the demand for the issuer’s securities.

In short, there are numerous good reasons why a business would want to issue convertible securities.

Impact of Convertible Securities on Earnings per Share

When investors convert their securities into the common stock of the issuer, this dilutes the ownership interests of existing stockholders. This dilution effect is included in the diluted earnings per share figure, which is reported in the financial statements of publicly held entities.