If preferred stock is convertible, it can be converted into common stock of the same issuer. As discussed in the common stock review, issuing convertible securities is a dilutive action for common stockholders. Because of that, the issuer must obtain stockholder approval to issue convertible preferred stock or convertible bonds.
Convertible bonds are discussed in a future section.
Convertibility benefits the stockholder because it creates two potential sources of return. Preferred stock and common stock tend to benefit investors in different ways.
Preferred stock is primarily used as a fixed income investment, typically paying quarterly income. Although the market price of preferred stock can change, most investors don’t buy preferred stock for capital appreciation. Capital appreciation occurs when an investor buys a security at a lower price and later sells it at a higher price. Preferred stock prices generally don’t offer the same level of volatility (and therefore opportunity) that investors usually look for when seeking capital gains.
Common stock can serve multiple purposes. Some issuers pay regular quarterly dividends, which is more typical for larger, established companies with consistent profits. However, most common stock investors focus on capital appreciation. Compared with preferred stock, common stock prices tend to be more volatile, which creates more opportunities for capital gains.
Convertible preferred stock gives the investor the option to exchange preferred shares for common shares. Investors consider converting for several reasons, but a common one is that conversion may be profitable.
Let’s assume the following:
A $100 par, 5% convertible preferred stock with a conversion ratio of 4:1 is trading at $100 per share.
The conversion ratio tells the preferred stockholder how many shares of common stock they’ll receive for each preferred share converted. The conversion ratio is set when the preferred stock is issued and does not change. In this example, the investor receives 4 shares of common stock for every 1 share of preferred stock.
Back to our example:
An investor purchases 100 shares of $100 par, 5% convertible preferred stock at $100 per share. The preferred shares have 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 sells the common stock. 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. Convertibility can increase an investor’s potential return, so issuers can often sell convertible preferred stock with lower dividend rates than comparable non-convertible preferred stock. Convertible securities also tend to be in higher demand, which can lead to higher market prices and lower yields.
Convertible preferred stock questions won’t always give the conversion ratio directly, but they will provide enough information to find it. On the Series 7, questions often provide the conversion price instead.
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 into 4 shares of common stock. Therefore, the conversion ratio is 4 to 1.
Sometimes, exam questions provide the conversion ratio and ask for the conversion price.
For example:
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 very similar:
Using this formula, can you find the conversion price?
Answer = $25
If the preferred stock is bought at par ($100), it 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 work through a more challenging question.
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 greatest return. Of the four choices, three are realistic (A, B, and C). Choice D isn’t realistic because the shares are being called; the investor must allow the call, sell the preferred shares, or convert. After the call date, the preferred shares will be redeemed and will no longer exist as an investment.
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. With $100 par, the investor receives $102 per share.
B) $103 per share
The call is announced but won’t occur for 60 days, so the preferred stock can still be sold in the market. The current market price is $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:
Since choice C provides the highest value, it’s the best recommendation.
In the previous question, you compared the value of converting versus other choices. Another way to evaluate conversion is with parity price.
There are two parity prices:
The common stock parity price is used to find the effective cost per share of the 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:
Now use the common stock parity price formula:
This means that buying the preferred stock at $55 and converting is equivalent to paying $11 per share for the common stock.
If the common stock is trading above $11, there’s an opportunity for an instantaneous profit. For example, if the common stock is at $15, an investor could:
That’s a $20 gain per preferred share.
That kind of instantaneous profit opportunity is called arbitrage. In real markets, arbitrage opportunities usually last only seconds or minutes. Investors often use computer systems to identify them quickly.
Let’s use the same numbers:
Preferred stock market price = $55
Conversion ratio = 5:1
Common stock market price = $15
If a system identifies this arbitrage opportunity, it could simultaneously:
Because conversion can take time to settle, the common stock price could change before the investor receives the converted shares. Selling short locks in the $15 sale price immediately. When the common shares arrive from conversion, the investor delivers them to close out the short position.
In exam questions, if a profit can be made by buying the convertible security, immediately converting, and selling the common stock, that’s arbitrage.
The second parity price is the preferred stock parity price, which values the preferred stock based only on what it can be converted into.
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:
Now use the preferred stock parity price formula:
This means the conversion feature alone is worth $24 (2 shares of common stock at $12 each).
If the preferred stock can be bought for less than $24, an arbitrage opportunity exists. For example, if the preferred stock is trading at $20, an investor could buy at $20, convert, and sell the common stock for $24 total - earning $4 per preferred share.
Ultimately, parity price helps investors decide whether conversion makes financial sense. If conversion creates an instantaneous profit, that’s an arbitrage opportunity.
Here’s a video that analyzes two different preferred stock parity price questions:
The last topic for convertible preferred stock is the anti-dilution covenant. Nearly every convertible security includes one. It’s a promise from the issuer to protect the value of the conversion feature if the issuer takes actions that would otherwise dilute it.
To see why this matters, start with a parity example:
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 feature is at breakeven (parity). If an investor buys the preferred stock at $100, converts into 4 common shares, and sells those shares for $100 total ($25 x 4), there’s no gain or loss.
If the common stock price rises above $25, conversion becomes attractive. Issuers monitor this closely because conversion creates new common shares, which dilutes the ownership percentage and value of existing common stockholders.
Without protection, the issuer could take actions that reduce the common stock price and therefore reduce the value of the conversion feature. Two common examples are stock splits and stock dividends.
Using the same starting point:
$100 par convertible preferred stock
Preferred stock market price = $100
Conversion ratio = 4:1
Common stock market price = $25
2:1 stock split
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 change, the conversion value drops from $100 to $50. That’s dilution for the preferred stockholder.
Now consider a stock dividend:
25% stock dividend
A 25% stock dividend increases shares outstanding by 25%, and the price per share falls proportionately ($25 / 1.25 = $20). If the conversion terms don’t change, the conversion value drops from $100 to $80.
If you need a refresher on how to calculate changes to positions because of stock splits or dividends, please review this section in the common stock chapter.
To prevent this kind of dilution, the anti-dilution covenant requires the issuer to adjust the conversion terms when a stock split or stock dividend occurs. In practice, that means adjusting the conversion price and conversion ratio so the conversion value stays consistent.
Work through this example:
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. If the preferred stock contains an anti-dilution covenant, what is the adjustment to the conversion price and ratio?
Start by finding the original conversion ratio.
Originally, 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 receive 2 shares worth $10 each, or $20 total - far below the original $80 conversion value. With an anti-dilution covenant, the issuer adjusts the conversion terms to preserve that $80 value.
To find the new conversion ratio, multiply the original conversion ratio by the stock split factor:
Now each preferred share converts into 8 common shares. At $10 per share, the conversion value is $80 (8 x $10), matching the original value.
With that in mind, what’s the new conversion price?
Answer = $12.50
You can find this two ways.
Method 1: adjust by the stock split factor
Divide the original conversion price by the stock split factor:
Method 2: use the new conversion ratio
Either method gives the same result.
Anti-dilution adjustments for stock dividends work the same way, except you use the stock dividend factor instead of the stock split factor.
Try this one:
An investor purchases a $50 par, 8% convertible preferred stock with a conversion price of $5. The common stock is currently trading at $6. The issuer performs a 25% stock dividend on the common stock. If the preferred stock contains an anti-dilution covenant, what is the adjustment to the conversion price and ratio?
Answers:
First, find the original conversion ratio:
Originally, each preferred share converts into 10 common shares. With common stock at $6, the conversion value is $60 (10 x $6).
A 25% stock dividend has a stock dividend factor of 1.25 (1 + 0.25). To find the new conversion ratio, multiply the original ratio by the stock dividend factor:
After the dividend, the common stock price adjusts to $4.80 ($6 / 1.25). The conversion value is still $60:
To find the new conversion price, divide the original conversion price by the stock dividend factor:
You can also confirm using the new conversion ratio:
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