Convertible Preferred Stock

Convertible Preferred Stock

Convertible preferred stock is a class of preferred shares that pays fixed dividends and includes an option to convert into a specified number of common shares after a predetermined date. It combines features of both debt-like preferred stock (steady dividends and higher claim on assets) and equity (potential for capital appreciation through conversion).

Key takeaways

• Pays a fixed dividend like regular preferred stock, but can be converted into common shares at a preset conversion ratio.
• Acts as a hybrid security—partly bond-like when conversion is unlikely, partly equity-like when conversion is attractive.
• Converting sacrifices preferred rights (fixed dividend, senior claim) in exchange for voting rights and exposure to share price appreciation.

How it works

Issuers set a conversion ratio (the number of common shares received per preferred share) when the convertible preferred stock is issued. The investor decides whether to convert based on the market price of the common shares relative to the conversion price. Companies sometimes include provisions to force conversion under specified conditions.

Conversion price formula:
* Conversion price = Par value of the preferred share ÷ Conversion ratio

Conversion is typically beneficial when the common share price exceeds the conversion price, making the equity value received higher than the preferred share’s market value.

Common terms

• Par value: The face value of the preferred share—used in certain calculations and in liquidation scenarios.
• Conversion ratio: Number of common shares each preferred share converts into.
• Conversion price: Implied price per common share at conversion (par value ÷ conversion ratio).
• Conversion premium: The dollar or percentage amount by which the preferred’s market price exceeds the market value of the common shares it converts into.
• Dollar premium = Preferred market price − (Common market price × Conversion ratio)
• Percentage premium = Dollar premium ÷ Preferred market price

Example

ABC Inc. issues convertible preferred shares with:
* Par value: $1,000
Conversion ratio: 10 (so conversion price = $1,000 ÷ 10 = $100)
Dividend: 5%

If ABC common shares trade at $80:
* Value of converted common shares = $80 × 10 = $800
* Conversion premium = $1,000 − $800 = $200 (20%)

If common shares rise to $110:
* Converted value = $110 × 10 = $1,100 → a 10% gain on the $1,000 preferred if converted and sold.

Risks of converting

• Loss of preferred protections: After conversion, holders forfeit the fixed dividend and senior claim on assets.
• Price volatility: Converted common shares are subject to market swings; a post-conversion decline can produce significant unrealized losses compared with holding the preferred.
• Timing risk: Conversion is often irreversible and may be poorly timed relative to market movements.

How convertible preferred differs from related securities

• Versus regular preferred stock: Convertible preferred adds an option to convert to common shares, so it usually trades at a premium and often pays a lower dividend than non-convertible preferred.
• Versus convertible bonds: Convertible bonds are debt instruments (creditors) and typically have priority over preferred shareholders in bankruptcy. Bonds pay interest and commonly have a maturity date; preferred shares normally do not mature.

Why investors buy convertible preferred stock

• Downside protection with upside potential: Investors receive steady dividends and a higher liquidation priority, plus the option to participate in equity appreciation.
• Flexibility: Ability to switch from a more conservative preferred position to equity exposure when stock performance justifies conversion.
• Potentially higher total return than straight preferreds if the underlying common stock performs well.

Bottom line

Convertible preferred stock is a hybrid security that provides a fixed-income-like dividend and the option to participate in equity gains. Its attractiveness depends on the conversion terms and the relative performance of the underlying common shares. Investors should weigh the trade-offs between dividend income and potential capital appreciation, and consider the conversion premium and post-conversion risks before converting.