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Convertible Preferred Stock: Everything You Need to Know
Debbie Carlson Oct 22, Invesco Preferred ETF. Charles Schwab. Global X U. The conversion ratio is the number of shares of stock that can be converted for each convertible security. As another way to calculate the conversion ratio, the conversion price is the specified stock price used in determining the conversion ratio. The conversion price is specified before the convertible security is issued, and is always higher than the market value of the stock on the date of issue; otherwise, bond buyers would immediately convert their bonds into stock, thereby defeating the purpose of issuing the security in the 1st place.
The current stock price determines whether the convertible security will be converted or not. Most convertibles are issued deep out of the money, so the stock must appreciate considerably before it would be profitable to convert. The conversion value is the value received if the convertible was converted into stock.
How convertible securities are valued
The convertible bond is more valuable than a straight bond, because the convertible can be considered to consist of 2 securities — the straight bond and a call option to buy company stock for the conversion price. If the stock price is below the conversion price, then the option only has time value, making the convertible bond only a little more valuable than the straight bond.
As the stock price increases, the call option becomes more valuable. As the stock price increases above the conversion price, the bond price moves proportionately higher.
Quick Category Facts
The convertible bond value is always a little greater than the conversion value, because the bond provides some protection against a stock price decline. If the stock declines below the conversion value, then the bond still has worth as a straight bond. Thus, a convertible security is like owning the stock with a protective put that has a strike price of the straight bond.
Note, also, that a stock price above the conversion price will be a major determinant of the bond's price, and will lower the yield-to-maturity rate on the bond as the bond's value increases with the stock price. However, the value of the call feature of convertibles is difficult to calculate because the stock may have paid dividends during the life of the convertible, the conversion price might rise at specified times, and most convertibles are callable.
A forced conversion occurs when the company issues a call on the convertible when the conversion price is below the stock price.
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The bondholders have about a month to convert, so if the current stock price is higher than the conversion price, the bondholder will convert the bond to stock for an immediate profit. Warrants, also called subscription warrants or stock-purchase warrants , are call options written by a company to buy its common stock at a specified price, usually within a specified time, although perpetual warrants have no expiration date. The money paid by the initial warrant buyer goes directly to the company as well as the money paid to exercise the warrant to receive company stock.
When the warrant is exercised, the company must issue new shares of stock, increasing the number of shares outstanding. These new shares are accounted for in financial reports as fully diluted earnings per share , which is what the earnings per share would be if all warrants were exercised and all convertible securities outstanding were converted. The terms of the warrant are determined by the needs of the company, and, thus, are not standardized like listed options, but warrants are adjusted for stock splits and stock dividends.
Warrants are frequently issued attached to bonds or preferred stock to reduce the interest or the dividends that must be paid to sell these securities. However, these warrants are detachable — thus, they are called detachable warrants — and can be traded independently of the attached security.