If preferred stock is convertible, it can be converted into common stock of the same issuer. As we discussed in the common stock review, the issuance of convertible securities is a dilutive action to the common stockholders. Therefore, the issuer must obtain voter approval to issue convertible preferred stock or bonds.
Convertible bonds are discussed in a future section,
Convertibility is a benefit to the stockholder, as it provides two separate ways for the investor to make a return. As you know, preferred stock and common stock benefit investors in different ways.
Preferred stock is primarily utilized as a fixed income investment, which typically pays semi-annual income to its investors. Although the market price of preferred stock varies, very few investors purchase preferred stock for capital appreciation purposes. Remember, capital appreciation occurs when an investor purchases a security at a low price, then sells the same security at a higher price. Preferred stock prices are not as predictable or volatile for most investors to seek capital gains (a.k.a. capital appreciation).
Common stock can be a jack of all trades. Some issuers of common stock pay regular quarterly dividends to their stockholders. This is typical for larger, well-established companies with consistent profits. Most common stockholders invest for capital appreciation. When comparing the common stock market to the preferred stock market, you’ll find much more price volatility and opportunities to make capital gains with common stock.
Convertible preferred stock offers the opportunity to change the investment into shares of common stock. There are several reasons why an investor would consider converting. First, it may be a profitable move. 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 receive if they convert their shares. The conversion ratio is set when the preferred stock is originally issued and does not change. In this example, the preferred stockholder will receive 4 shares of common stock for every preferred share owned.
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 the last example, the investor made a profit because the common stock price increased. Convertibility is a benefit for investors, as it provides more potential for return. Therefore, the issuer can sell convertible preferred stock with lower dividend rates than non-convertible preferred stock. Additionally, convertible securities are attractive in the market, which drives higher market prices and lower yields for these types of investments.
Convertible preferred stock questions won’t always provide the conversion ratio, but they must always give enough information to find the conversion ratio. In particular, Series 7 conversion questions typically provide the conversion price instead. The conversion price reflects the overall cost of the common stock (per share) if the preferred stock is purchased for par and 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 can 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 to the conversion ratio formula:
Using this formula, can you find the conversion price?
Answer = $25
If the preferred stock was bought at par ($100), it could be converted into 4 shares of common stock. Essentially, the investor is paying $25 per share of common stock ($100 / 4), which is the conversion price.
Now, let’s dive into some more difficult questions involving convertible preferred stock.
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
It’s your job to recommend the option that provides the most return to your customer. Of the four choices, three are legitimate (A, B, and C). Answer choice D is not valid; the preferred shares are being called and the investor must allow the shares to be called, sell the preferred shares, or convert to common. Continuing to hold the shares beyond the call date is not a realistic option. The preferred shares will no longer pay dividends after the call, rendering them useless.
For answer choices A, B, and C, it’s best to determine how much each option provides:
A) $102 per share
The preferred shares are callable at 102, which means it will cost the issuer 102% of par ($100) to call. For every share owned, the investor receives $102.
B) $103 per share
Although the preferred stock has been called, it won’t be called for 60 days and will continue to trade in the market. The market price is $103, providing the opportunity to the investor to sell their shares at that price.
C) $104 per share
If the investor converts, it’s important to know the conversion ratio. This can be found by dividing par ($100) by the conversion price ($25), which is 4. With the common stock currently trading for $26, the investor can convert each preferred share to 4 common shares, which equals $104 of overall value (4 x $26).
With answer choice C providing the most value, it’s the best recommendation.
In the previous question, it was important to know the financial benefit of converting to common stock. Another way to determine if a conversion should occur involves parity price. There are two types of parity price: preferred stock parity price and common stock parity price.
Let’s start first with the common stock parity price, which is utilized by investors to determine the cost of the common stock if converted. The formula is:
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, you’ll need to find the conversion ratio. The question provides the conversion price ($10). The calculation for the conversion ratio is:
For every 1 share of preferred stock, the investor may convert it into 5 shares of common stock. From there, you can utilize the parity price formula for common stock:
The parity price establishes the price per share paid for the common stock if the preferred stock is purchased and immediately converted. A $55 share of preferred stock that’s convertible into 5 shares of common stock results in a “cost” (parity price) of $11 per share of common stock.
If the common stock was trading for any price above $11 in the market, there would be an opportunity for instantaneous profit. For example, assume the common stock is trading at $15. An investor could buy a share of preferred stock for $55, convert it into 5 shares of common stock, and sell all of those shares for $75 (5 shares x $15). This would result in a $20 gain per share of preferred stock.
In the previous example, we discussed the opportunity for an instantaneous profit. While it doesn’t occur frequently in the market, we refer to those events as arbitrage opportunities. Typically, these opportunities only last for minutes or seconds in the real world. Many times, investors need computer systems to scour the market for these fleeting moments. If spotted, the investor would likely go long and short simultaneously to lock in a profit.
Let’s go through a quick example to better understand this. Assume the numbers from the previous example:
Preferred stock market price = $55
Conversion ratio = 5:1
Common stock market price = $15
If a computer system identified this arbitrage opportunity, it would simultaneously buy shares of preferred stock and sell short the corresponding amount of common stock. Receiving the common stock from the conversion typically takes some time, and the market price may change in the meantime. By selling short the common stock, the investor locks in the $15 market price immediately. When the common shares are received from the conversion, the investor gives those shares to their financial firm to close out the short position.
In some questions, you’ll be asked to identify if an arbitrage opportunity exists. If a profit can be made by buying the convertible security, immediately converting to common stock, and selling those shares, it’s arbitrage.
There’s one more type of parity price to go through. This is the formula for the preferred stock parity price:
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, you’ll need to find the conversion ratio. The question provides the conversion price ($15). The calculation for the conversion ratio is:
For every 1 share of preferred stock, the investor may convert it into 2 shares of common stock. From there, you can utilize the parity price formula for common stock:
The parity price establishes the overall value of the preferred stock based solely on the conversion feature. If a security can be converted into 2 shares of common stock, and the common stock is worth $12 per share, then the conversion feature is worth $24.
If the preferred stock could be purchased in the market for less than $24, an arbitrage opportunity exists. For example, assume the preferred stock is trading at $20. The investor could buy a share of preferred stock (at $20), convert it into common stock, and sell those shares for $24 overall. The investor makes a $4 profit per share of preferred stock.
Ultimately, parity price is utilized by investors in convertible securities to determine if they should convert to common stock. If the investor can make an instantaneous profit, an arbitrage opportunity exists.
Here’s a video that analyzes two different preferred stock parity price questions:
The last topic to cover regarding convertible preferred stock involves something called the anti-dilution covenant. Nearly every convertible security is issued with it, which is a promise from the issuer to avoid diluting the value of the conversion feature. Before we discuss how the anti-dilution covenant protects preferred stockholders, let’s go through how they could be diluted without it.
Assume the following:
$100 par convertible preferred stock
Preferred stock market price = $100
Conversion ratio = 4:1
Common stock market price = $25
In this circumstance, the conversion feature is at breakeven (parity). If the investor buys a share of preferred stock at $100, converts it into 4 shares of common stock, and sells those shares for $100 overall ($25 x 4), they will not make or lose any money. This is parity.
If the common stock price rises any further, there’s a big incentive for investors to begin converting their preferred shares. You can safely assume some employee of the issuer (likely the Chief Financial Officer) is keeping a close eye on this. While the issuer had to obtain stockholder approval to issue the convertible preferred stock, it doesn’t mean they’ll be thrilled if a significant amount of preferred shares start converting. Remember, conversion results in brand new shares of common stock, which dilutes the value and ownership level of every common stockholder (which likely includes the officers and directors of the issuer).
The issuer could do several things to manipulate the price of the common stock downward, resulting in the conversion feature having less value. In particular, stock splits and stock dividends would do the job. Again, assume the following:
$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 results in twice as many shares outstanding with each share trading at half its original value. This results in the conversion value being cut in half. Before the stock split, the conversion netted $100 of common stock ($25.00 x 4), but after it only nets $50 of common stock ($12.50 x 4) At this point, it’s not likely any conversions occur. This is an example of dilution for the preferred stockholders.
Assuming the same example, let’s look at what would happen if a stock dividend occurred:
25% stock dividend
Again, an issuer action reduced the value of the conversion feature. With a 25% stock dividend, the number of shares outstanding increases by 25%, while the price per share decreases proportionately ($25 / 1.25 = $20). Before the stock dividend, the conversion netted $100 of common stock ($25.00 x 4), but after it only nets $80 of common stock ($20.00 x 4).
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 avoid this problem, nearly every convertible security is issued with an anti-dilution covenant. It’s a promise to the convertible security owner that the issuer will make adjustments to the conversion feature if a stock split or dividend occurs. Specifically, the issuer will change the conversion price and ratio to offset the dilution. Let’s explore this idea with a question:
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?
Let’s walk through this one together. The first step is to find the original conversion ratio.
In the beginning, each share of preferred stock is convertible into 2 shares of common stock worth $40 each. Prior to the stock split, the conversion feature is worth $80 ($40 x 2). If a 4:1 common stock split occurs, the share price will fall significantly.
With the common stock’s price falling to $10 per share, the conversion feature’s value falls to $20 if it doesn’t adjust (converts into 2 shares worth $10 each). With the anti-dilution covenant, the issuer will make an appropriate adjustment to the conversion price and ratio. Remember, they must make the proper change to retain the original conversion value of $80. Let’s start first with the conversion ratio.
To find the new conversion ratio, simply multiply the current conversion ratio (2) by the stock split factor (4) (again, review the stock split & dividend section if you don’t know how to find the stock split factor).
Because the issuer created 4 times the number of common shares outstanding, the preferred stockholders should receive 4 times the original amount received at conversion. If the investor converts now, they’ll receive 8 shares of common stock worth $10 each. This represents a conversion value of $80 (8 x $10), matching the original value.
With that being said, do you know what the new conversion price would be?
Answer = $12.50
You can find this one of two ways. First, let’s only use the stock split factor. A 4:1 stock split results in a stock split factor of 4 (4/1). We multiplied this number times the conversion ratio to find the new conversion ratio. To find the new conversion price, you’ll need to divide the original conversion price ($50) by the stock split factor (4).
The other way can only be used if the new conversion ratio has been calculated. We know the new conversion ratio is 8, so we could simply do the traditional conversion price formula:
Either way works! Feel free to use whichever way is more comfortable for you.
Anti-dilution adjustments for stock dividends are very similar. The only difference is using the stock dividend factor instead of the stock split factor. Let’s see if you calculate this one on your own:
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, let’s figure out the original conversion ratio:
In the beginning, a share of preferred stock can be converted into 10 shares of common stock. With the common stock currently trading at $6 per share, the conversion feature is currently worth $60 (10 x $6). Now, the issuer performs a 25% stock dividend, which will drive down the price of the common stock. The anti-dilution covenant will force the issuer to make adjustments to the conversion price and ratio.
Let’s start with the conversion ratio first. With a stock dividend of 25%, the stock dividend factor is 1.25 (1 + 0.25). To find the new conversion ratio, multiply the original ratio by the stock dividend factor:
When preferred stockholders convert now, they’ll receive 12.5 shares of common stock, which will be worth $4.80 per share after the dividend ($6 / 1.25). This results in a conversion value of $60 (12.5 x $4.80), which matches the original value.
To find the new conversion price, we can divide the original conversion price by the stock dividend factor:
You could also use the new conversion ratio to find the same answer:
Whew! That was a bunch of numbers. If it all made sense to you, great! You’ll do well when you see questions on this material. If it felt overwhelming, hang in there! With convertible securities, practice makes perfect. Be sure to work through enough questions to feel comfortable.
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