Convertible Securities’ Risks to Common Stock Holders
Before investing in the common stock of a company, you should first find out whether the company is issuing convertible securities or not. If it is, find out whether such convertible securities are converted using a fixed-price or a market-price formula. Between these two, the later poses more risks to bearers of common stock.
To find out if a company is at risk from the negative effects of convertible securities (especially market-price convertibles), use SEC's searchable database for a company's SEC filings. Of particular interest are the company's quarterly or annual report - specifically, Forms 8-K, 10-Q and 10-K that will tell you if a company has issued any unregistered convertible securities anytime in the past.
The following are some of the main risks you face if you invest in a company that has issued convertible securities:
Dilution: Convertible stocks, when converted, increase the number of common
stocks. This dilutes common stock investors' proportional ownership interests
in the company.
Ownership dilution is a consequence of converting both fixed-price and market-price convertibles. In the case of the former, however, ownership dilution occurs at a more controlled rate. Thus, market-price convertibles are more disadvantageous to common stock holders than fixed-price convertibles.
Reduction: As a consequence of the increase in the number of shares of
common stock, the earnings per share (EPS) also decline. The company's net
income is distributed among a greater number of shares, thus the reduction in
revenues per share.
Like ownership dilution, revenue reduction is a disadvantage common to both fixed-price and market-price convertibles. Once again, however, conversion of market-price convertibles can potentially lead to a much greater rate of revenue reduction than conversion of fixed-price convertibles.
Crashes: Since conversion of convertible securities lead to a reduction in
revenues per share and ownership dilution, stock price declines almost always occur
after the convertible securities are converted. Such stock price declines are
further aggravated by loss of investor confidence.
For instance, common stock holders, after convertible securities are converted or as the conversion period approaches, may give up their shares to minimize his losses. The resulting increase in the supply of the common stock drives down this stock's price even further.
Stock price declines are usually greater in conversions involving market-price convertibles due to the greater ownership interest and revenue dilution that they induce.
The Greater Risk Posed by Market-Price Convertibles to Common Stock Holders
Why do market-price convertibles pose a greater risk to common stock holders of a company?
Since conversion of securities often leads to stock declines, such convertible securities are often converted at a significantly discounted market price. Subsequently, market-price convertible securities are able to command an even greater number of common stock shares. This, in turn, leads to greater ownership dilution and revenue reduction, which further drive down stock prices and even greater loss of investor confidence. Further conversions, therefore, will command even more common stock shares. This will lead to the escalation of the negative effects (even greater dilution of shares and even greater reduction of revenues).
Theoretically, the negative consequences resulting from the conversion of market-price convertible securities can go on indefinitely until the common stock becomes virtually worthless.
The Risk to Holders Market-Price Convertible Securities
Since the value of convertible securities are tied to the value of the common stock to which it will be converted, significant common stock price reductions also devalue a convertible security account's value.
When the company's common stock is virtually worthless, there's not much point in converting convertible securities into common stock. In other words, securities that may be converted to a practically worthless common stock may just as well be worthless themselves.
This potential to self-destruct has made market-price convertibles highly unpopular among some investors. They have resorted to calling market-price convertibles names that pertain to the great risks they pose. Some of the more colorful names used to refer to market-price convertibles are death spiral convertibles, floorless convertibles, toxic convertibles, or ratchet convertibles.
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