Convertible preferred stock allows investors to exchange their security for common stock of the same issuer. To understand how this security works, this chapter covers four subtopics:
Convertibility benefits the preferred stockholder by adding another potential source of return: capital appreciation.
Preferred stock is generally treated as a fixed-income investment. It typically pays quarterly dividends, and while its market price can change, most investors don’t buy preferred stock primarily for growth. Preferred prices tend to be less volatile and less growth-oriented than common stock.
Common stock, by contrast, is usually purchased for its growth potential. Over long periods, stock market returns have averaged around 10% annually, which can translate into meaningful capital gains. Some common stocks also pay cash dividends, so an investor who converts may still receive income.
Issuing a convertible security is a dilutive action for common stockholders because conversion can increase the number of common shares outstanding and reduce each existing shareholder’s percentage ownership.
To see why, assume you own 10 shares of a company with 100 shares outstanding. That gives you 10% ownership. Now assume the company issues convertible preferred shares that would create an additional 100 common shares if converted. If all holders convert, there are now 200 shares outstanding (100 original + 100 new). You still own 10 shares, but now that’s 10/200 = 5% ownership.
Because dilution can negatively affect common stockholders, the issuer must obtain voter approval to issue convertible preferred stock or bonds.
Let’s work through a few examples to get comfortable with convertible preferred stock.
A $100 par, 5% convertible preferred stock with a conversion ratio of 4:1 is trading at $100 per share.
The conversion ratio tells you how many shares of common stock you receive if you convert one share of preferred stock. The issuer sets the conversion ratio at issuance, and it generally stays fixed over the life of the security.
In this example, a converting preferred stockholder receives 4 shares of common stock for every 1 preferred share.
Back to our example:
An investor purchases 100 shares of $100 par, 5% convertible preferred stock at $100 per share. The preferred shares maintain a conversion ratio of 4:1, while the common stock is trading at $15. A few years later, the common stock rises to $30. The investor converts their shares to common stock and immediately liquidates the position. What is the gain or loss?
Can you figure this one out?
Answer = $2,000 gain
Step 1: preferred stock purchase
Step 2: convert into common shares
Step 3: sell common shares
Step 4: compare the original purchase to final sale
In this example, the investor profits because the common stock price rises. That’s the key advantage of convertibility: it gives the preferred stockholder a path to participate in common stock appreciation.
Because convertibility adds value, convertible preferred stock is typically issued with lower dividend rates than non-convertible preferred stock. Convertible securities also tend to trade at higher market prices, which generally means lower yields (the higher the price you pay, the lower the yield, all else equal).
Convertible preferred stock questions won’t always give you the conversion ratio directly. Instead, they often provide the conversion price.
The conversion price is the effective price per share of common stock if the preferred stock is purchased at par and then converted.
For example:
An investor purchases 100 shares of a $100 par, 5% preferred stock convertible at $25. What is the conversion ratio?
The formula for the conversion ratio is:
Using this formula, can you find the conversion ratio?
Answer = 4:1
For every share of preferred stock owned, the investor can convert it into 4 shares of common stock. Therefore, the conversion ratio is 4 to 1.
Sometimes, exam questions give the conversion ratio and ask for the conversion price.
An investor purchases 100 shares of a $100 par, 5% preferred stock with a 4:1 conversion ratio. What is the conversion price?
The conversion price formula is:
Using this formula, can you find the conversion price?
Answer = $25
Preferred stock bought at par ($100) can be converted into 4 shares of common stock. That means the investor is effectively paying $25 per share of common stock ($100 / 4), which is the conversion price.
Now let’s apply these ideas to a more realistic decision.
An investor purchases shares of a $100 par, 7% preferred stock, which is convertible at $25 and callable at 102. A few years later, the preferred stock is trading at $103, while the common stock is trading at $26. If the issuer announces an upcoming call of the preferred stock in 60 days, which of the following options should you recommend to the investor?
A) Allow the shares to be called
B) Sell the preferred stock
C) Convert to common and sell the shares
D) Continue to hold the preferred stock
Can you figure out the best answer?
Answer: C) Convert to common and sell the shares
Your recommendation should be the choice that provides the most value. Three of the four choices are realistic (A, B, and C). Choice D isn’t realistic because the shares will be called; holding beyond the call date isn’t an available outcome.
Now compare the value of A, B, and C.
A) $102 per share
The preferred shares are callable at 102, meaning the issuer will pay 102% of par. For each share, the investor receives $102.
B) $103 per share
The call won’t occur for 60 days, so the preferred stock can still trade in the market. At the current market price, the investor could sell for $103.
C) $104 per share
If the investor converts, first find the conversion ratio:
Each preferred share converts into 4 common shares. With common stock at $26, the conversion value is $104 (4 x $26).
Since choice C provides the highest value, it’s the best recommendation.
Another way to evaluate whether conversion makes sense is to use parity price. There are two parity prices:
The common stock parity price tells you the effective cost per share of common stock if you buy the preferred stock at its current market price and convert.
An investor purchases shares of a $50 par, 4% preferred stock at $55. The shares have a conversion price of $10. What is the parity price of the common stock?
Can you figure it out?
Answer = $11
First, find the conversion ratio using the conversion price ($10):
Now use the common stock parity price formula:
This means buying the preferred at $55 and converting is equivalent to paying $11 per share of common stock.
An instant profit exists if the common stock trades above $11. For example, if the common stock is at $15, an investor could:
That’s a $20 gain per preferred share.
That “instant profit” situation is an arbitrage opportunity. In real markets, these opportunities usually disappear quickly.
Using the same numbers:
Preferred stock market price = $55
Conversion ratio = 5:1
Common stock market price = $15
A trader (often using automated systems) could:
Because conversion and delivery of the common shares can take time, shorting the common stock helps lock in the current market price. When the common shares arrive from conversion, they’re used to close the short position.
On exam questions, if buying the convertible security, immediately converting, and selling the common stock produces a profit, that’s arbitrage.
The preferred stock parity price tells you what the preferred stock would be worth based only on the conversion feature.
An investor purchases shares of a $30 par, 4% preferred stock. The shares have a conversion price of $15, while the common stock is trading at $12. What is the parity price of the preferred stock?
Can you figure it out?
Answer = $24
First, find the conversion ratio using the conversion price ($15):
Now use the preferred stock parity price formula:
This means the conversion feature alone implies a value of $24 for the preferred stock.
An arbitrage opportunity exists if the preferred stock trades below $24. For example, if the preferred is at $20, an investor could buy it, convert, and sell the common stock for $24 total - earning $4 per preferred share.
Investors use parity prices to help decide whether conversion makes sense. If conversion creates an immediate profit, an arbitrage opportunity exists.
Here’s a video that analyzes two different preferred stock parity price questions:
Virtually all convertible preferred stocks are issued with anti-dilution covenants, which are the issuer’s promise to avoid diluting the value of the conversion feature.
To see why this matters, start with a situation where the conversion feature is at breakeven (parity).
Assume the following:
$100 par convertible preferred stock
Preferred stock market price = $100
Conversion ratio = 4:1
Common stock market price = $25
Here, the conversion value equals the preferred’s market price:
If the common stock price rises, conversion becomes more attractive. However, conversion creates new common shares, which dilutes existing common shareholders’ ownership and value.
Without an anti-dilution covenant, the issuer could take actions that reduce the common stock price and weaken the conversion feature. A stock split is a classic example.
Again, assume:
$100 par convertible preferred stock
Preferred stock market price = $100
Conversion ratio = 4:1
Common stock market price = $25
2:1 stock split
*Stock splits were initially covered in this chapter.
A 2:1 stock split doubles the number of shares outstanding and cuts the price per share in half. If the conversion terms don’t adjust, the conversion value falls from $100 to $50. That makes conversion much less appealing, and the convertible preferred stockholders have effectively been diluted.
Anti-dilution covenants require the issuer to adjust the conversion terms when a stock split occurs. The issuer changes the conversion price and conversion ratio so the conversion feature keeps the same economic value.
Let’s apply that idea.
An investor purchases a $100 par, 5% convertible preferred stock with a conversion price of $50. The common stock is currently trading at $40. The issuer performs a 4:1 stock split on the common stock. What is the adjustment to the conversion price and ratio if the preferred stock contains an anti-dilution covenant?
Start by finding the original conversion ratio.
Initially, each preferred share converts into 2 common shares. With common stock at $40, the conversion value is $80 ($40 x 2).
After a 4:1 stock split, the common stock price adjusts as follows:
If the conversion terms didn’t change, the investor would still receive 2 shares worth $10 each, or $20 total. The anti-dilution covenant requires an adjustment so the conversion value remains $80.
To find the new conversion ratio, multiply the original conversion ratio (2) by the stock split factor (4) (again, review the stock split section if you don’t know how to find the stock split factor).
Now each preferred share converts into 8 common shares. At $10 per share, the conversion value is back to $80 (8 x $10).
Do you know what the new conversion price would be?
Answer = $12.50
You can find this two ways.
Method 1: adjust by the stock split factor
Divide the original conversion price ($50) by the stock split factor (4):
Method 2: use the conversion price formula with the new ratio
Either method gives the same result.
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