Convertible Securities Definition and Types
As the name implies, convertible securities are securities that may be converted from bonds or preferred stocks to (usually) common stocks.
They are often used by companies when they need additional capital but have no easy or ready access to such funds. Companies that have access to conventional sources of funding such as bank credit and public offerings generally don't use convertible securities as a financial tool unless doing so is part of a bigger business strategy.
Read the documents pertaining to a convertible security before purchasing shares. Read the fine print so you'll learn how a convertible security rates when it comes to the factors that influence the viability of convertible securities.
General Types of Convertible Securities
Holder vs. Company Control of Conversion
Who holds the discretionary power over the schedule of conversion has a big impact on your profits. Be sure to check whether convertible security investors have this power or whether the company has reserved this right before you invest in a convertible security.
In most cases, the right to decide when to convert convertible securities belongs to holders of these convertible securities. There are some convertible security contracts, however, that give this right to the security issuer.
Fixed vs. Market Price Based Conversion
There are two types of convertible securities according to the conversion formula used.
Fixed-price convertible securities are converted using a fixed conversion ratio. In a fixed-conversion scenario, the number of common stocks a holder of a convertible security will get upon conversion is already known at the time of the convertible security's acquisition. Simply put, x shares of a fixed-price convertible security converts to y shares of common stock every time.
Fixed-price convertible securities often come with other restrictions to minimize the dilution of common stock that will occur once the convertibles are converted into common stock.
Market-price-based convertible securities are converted using a conversion ratio adjusted for market price volatility. Convertible securities of this type are converted based on the discounted market price of the common stock.
The market price conversion formula benefits the holders of market price convertibles by minimizing the risk from declining common stock prices. If the common stock price declines (as they most probably will upon conversion of market price convertibles), the holder of the convertible security gains more common stock shares for his investment.
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