What is convertible preferred stock?
– Convertible preferred stock is a class of preferred shares that carries an embedded right for the holder to exchange each preferred share for a specified number of common shares at some time(s) in the future. The conversion feature gives holders potential upside tied to the common stock while retaining many of the income and priority characteristics of preferred stock.
Key characteristics (short definitions)
– Preferred stock: an equity claim that usually pays a fixed dividend and ranks above common stock for dividends and in liquidation, but typically lacks voting rights.
– Conversion ratio: how many common shares each preferred share can be converted into (e.g., 10 common shares per preferred share).
– Conversion price: the implicit price per common share implied by the preferred share’s issuance price divided by the conversion ratio (issuance price ÷ conversion ratio).
– Conversion premium: how much more the preferred is trading for relative to its immediate conversion value into common shares; often expressed as a dollar amount or percentage.
– Forced (or mandatory) conversion: a clause that lets the issuer require conversion under specified conditions.
– Call provision: the issuer’s right to redeem or call the preferred, which can affect conversion timing.
How the embedded conversion option works (plain steps)
1. Check the conversion ratio and conversion price disclosed in the offering terms.
2. Compute the conversion value = (current common price) × (conversion ratio).
3. Compare conversion value with the preferred share’s market price:
– If conversion value > market price of preferred, conversion may be immediately profitable.
– If conversion value < market price, the preferred will generally trade like fixed-income (driven by dividends and interest-rate moves).
4. Consider non-price factors: dividend yield on the preferred, loss of liquidation preference after conversion, potential voting rights gained, and issuer call or forced-conversion terms.
Worked numeric example (based on an illustrative company)
Assume ABC Inc. issues a convertible preferred at $1,000 with:
– Conversion ratio = 10 common shares per preferred
– Preferred dividend = 5% per year (paid in cash)
– Conversion price = $1,000 ÷ 10 = $100 per common share
a) Current common = $80
– Conversion value = $80 × 10 = $800
– Conversion premium (dollar) = preferred price − conversion value = $1,000 − $800 = $200
– Conversion premium (percent) = $200 ÷ $1,000 = 20%
Interpretation: The common would need to rise substantially before conversion becomes attractive; the preferred acts more like an income instrument.
b) Common rises to $110
– Conversion value = $110 × 10 = $1,100
– Conversion gain if converted and sold = $1,100 − $1,000 = $100 = 10%
Risk illustration after conversion: If you convert at $110 and keep the common, a later fall to $75 would leave you with $75 × 10 = $750 in common for each $1,000 preferred originally held — a notional loss of $250, and you would have given up the 5% preferred dividend and the preferred’s superior claim in liquidation.
Why issuers and investors use convertibles
– Issuers (often early-stage companies) can raise capital with less immediate dilution to common shareholders and may offer lower cash-dividend burdens.
– Investors receive a fixed income-like return (preferred dividend and priority) plus optional upside via conversion if the common performs well.
– Trade-offs for investors: convertibles usually sell at a premium to straight preferred and often carry a lower dividend rate than nonconvertible preferreds because of the conversion option’s value.
How convertible preferred differs from:
1. Regular (nonconvertible) preferred stock:
– Regular preferred has no conversion right, so it focuses solely on stable dividends and liquidation preference.
– Convertible preferred typically trades at a higher price and pays a lower dividend because buyers are paying for the conversion option.
2. Convertible bond:
– A convertible bond is debt and pays interest (coupon); it has priority over preferred equity in bankruptcy.
– Bonds usually have a stated maturity date; many preferreds are perpetual (no maturity).
– Converting a bond converts a creditor into an equity holder, changing legal seniority; converting preferred only converts among equity classes.
Risks to be aware of
– Equity risk after conversion: converted shares are common stock and can fall in value.
– Opportunity cost: lost preferred dividend and liquidation priority once converted.
– Interest-rate and credit sensitivity: when conversion looks unlikely (big conversion premium), the instrument behaves more like a bond and can be affected by rates and issuer credit.
– Liquidity and market pricing: convertibles can be thinnerly traded than common or plain-vanilla bonds; pricing includes option value which can be complex.
Checklist for evaluating a convertible preferred before buying
– Verify conversion ratio and conversion price.
– Check conversion period windows and any forced conversion or call features.
– Confirm dividend rate, payment frequency, and any cumulative/noncumulative status.
– Note liquidation preference and subordination relative to other claims.
– Calculate current conversion value and conversion premium.
– Compare yield (dividends) versus comparable fixed-income and preferred alternatives.
– Assess issuer fundamentals and outlook for the common stock; conversion value depends on future common performance.
– Confirm market liquidity and trading costs.
– Review tax rules applicable in your jurisdiction for dividends and capital gains.
Simple decision framework (practical)
1. Compute conversion value and premium.
2. Estimate expected common share appreciation probability
3. Estimate the income component and downside cushion.
– Compute current yield = annual dividend / preferred market price. Example: $6 annual dividend ÷ $105 market price = 5.71%.
– Compare yield to bonds and plain preferreds of similar credit quality and duration. A higher yield can compensate for lower conversion odds.
– Quantify downside cushion (if any) as (conversion value + liquidation preference — market price) relative to market price. If conversion value is well below market price, your cushion is essentially the dividend income only.
4. Calculate break-even common price and conversion premium in percent.
– Conversion value = conversion ratio × current common price.
– Break-even common price (for parity) = preferred market price ÷ conversion ratio.
– Conversion premium (%) = (preferred market price ÷ conversion value) − 1 = (preferred price − conversion value) ÷ conversion value.
– Example: Preferred market price = $105; conversion ratio = 2; common price = $40.
– Conversion value = 2 × $40 = $80.
– Break-even common price = $105 ÷ 2 = $52.50.
– Conversion premium = ($105 ÷ $80) − 1 = 31.25%.
5. Build a simple probabilistic payoff model (short form).
– Let p = probability common reaches break-even (or your target) by time T.
– Rough expected value at T (ignoring time value of money and taxes) ≈ p × (conversion ratio × expected common price at T) + (1 − p) × expected value if not converted (market price of preferred at T or redemption proceeds) + accumulated dividends to T.
– Use scenarios: optimistic (convert at target), base (preferred stays and pays dividends), pessimistic (issuer defaults or is diluted). Assign conservative probabilities to each.
– Example numeric sketch: using the $105 / 2 example above, assume in 12 months:
– If common hits $60 (probability 30%), converted value = 2 × 60 = $120.
– If not (probability 70%), preferred trades around $100 and pays $6 in coupons.
– Expected terminal value ≈ 0.3×120 + 0.7×100 + 6 ≈ $36 + $70 + $6 = $112 → implied 6.67% one‑year return. Adjust p and outcomes for your views.
6. Check corporate events, call and forced conversion mechanics.
– Identify issuer call dates, call price, and forced-conversion triggers (e.g., common price held above a level for N trading days). These alter conversion timing and upside capture.
– If callable below the market value of conversion, call risk can cap upside. Model scenarios with and without forced conversion.
7. Test sensitivity with a small scenario table (quick stress test).
– Create rows for common price outcomes (e.g., $30, $40, $50, $60, $80).
– For each row compute conversion value = CR × common price, conversion premium, and whether conversion or call would likely occur.
– This reveals how sensitive your return is to common-stock moves.
8. Liquidity, transaction costs, and taxes.
– Confirm typical bid-ask spreads and average daily volume for the preferred.
– Factor in commissions and the cost of hedging (if you plan to hedge delta exposure).
– Review tax treatment in your jurisdiction: preferred dividends can be taxed as ordinary income or qualified dividends depending on rules; capital gains on sale or conversion may have different treatment. Consult a tax advisor.
9. Decision checklist before buying (final go/no‑go).
– Are conversion terms clearly specified and favorable (CR, conversion price, adjustment clauses)? Yes/No.
– Does dividend yield plus downside protection meet your risk requirements compared with alternatives? Yes/No.
– Is the issuer’s credit and equity outlook acceptable? Yes/No.
– Are call/forced-conversion risks understood and priced? Yes/No.
– Can you accept the liquidity and tax consequences? Yes/No.
Worked numeric example summary (compact)
– Data: Preferred price $105; annual dividend $6; conversion ratio 2; common price $40.
– Metrics:
– Conversion value = 2 × $40 = $80.
– Current yield = $6 ÷ $105 = 5.71%.
– Conversion premium =
Conversion premium = ($105 − $80) ÷ $80 = $25 ÷ $80 = 31.25%.
Additional compact metrics and checks
– Parity price (implied common price at which conversion value = preferred price) = Preferred price ÷ Conversion ratio = $105 ÷ 2 = $52.50 per common share.
– Percent gain required in the common from current $40 to reach parity = ($52.50 − $40) ÷ $40 = 31.25% (same number as the conversion premium because of the definitions).
– Scenario outcomes (rounded):
– If common stays at $40: conversion value = $80 → paper loss vs preferred cost = ($80 − $105) ÷ $105 = −23.8%.
– If common rises to $52.50: conversion value = $105 → break‑even on conversion.
– If common rises to $60: conversion value = $120 → immediate gain if converted = ($120 − $105) ÷ $105 = 14.29%.
– Income while holding (if dividends are paid): current income yield = $6 ÷ $105 = 5.71% per annum, received until conversion/call/default.
Simple step‑by‑step analysis checklist before and after purchase
1. Calculate conversion parity and premium (formulas below) and interpret whether upside is realistic.
– Conversion value = Conversion ratio × Common share price.
– Conversion premium = (Preferred price − Conversion value) ÷ Conversion value.
– Parity common price = Preferred price ÷ Conversion ratio.
2. Compare the preferred’s dividend yield to similar fixed‑income and equity alternatives, adjusted for credit risk.
3. Read the fine print: call provisions, forced‑conversion triggers, put rights, anti‑dilution adjustments, dividend
provisions (cumulative vs. non‑cumulative), payment dates, whether dividends can be suspended, and whether missed dividends accrue. Also verify anti‑dilution language (how the conversion ratio adjusts for stock splits, spin‑offs, or rights offerings), and any restrictions on conversion timing (e.g., only after a set date or only when the common trades above a trigger).
4. Model scenarios — conversion, hold, and call
– Set assumptions. Example: you buy one preferred share at $105, it pays $6/year in dividends, and the conversion ratio is 0.5 (you receive 0.5 common shares if you convert). Current common price = $240, so conversion value = 0.5 × $240 = $120.
– Scenario A — Convert now. Conversion value $120 versus your cost $105 ⇒ net proceeds $15. Express as percentage: $15 / $105 = 14.29% gain on conversion (ignores taxes and transaction costs).
– Scenario B — Common rises to $300 in 1 year. Conversion value = 0.5 × $300 = $150. If you convert at that point, capital gain = $150 − $105 = $45 = 42.86% (again before taxes/fees). If instead you hold for one year and then convert, include dividend income: $6 received while holding lowers your effective net cost basis if you treat it as cash return (but tax treatment differs).
– Scenario C — Common falls to $200. Conversion value = 0.5 × $200 = $100. Converting now would realize a small loss: $100 − $105 = −$5 (−4.76%). But you may still have collected dividends while holding, which partially offsets the capital loss.
– Scenario D — Issuer calls the preferred in 2 years at $100 (call price). Your outcomes depend on whether call protection exists and on any forced‑conversion clause: if called, you may be forced to take the call price (possibly below your purchase price) or accept conversion on the issuer’s terms. Model the yield‑to‑call assuming: purchase $105, annual dividend $6, call in 2 years at $100. Approximate yield‑to‑call uses total cash flows: you receive $6
each year for two years (total $12) plus the $100 call price at the end of year 2. That makes total cash received = $112. Net gain relative to your $105 purchase = $7 over two years.
Step 1 — Simple total-return and simple annualization
– Total return = $7 / $105 = 0.066667 = 6.667% over 2 years.
– Simple annualized return ≈ 6.667% / 2 = 3.333% per year (a quick but imprecise method).
Step 2 — Exact yield‑to‑call (internal rate of return)
Yield‑to‑call is the internal rate of return (IRR) that sets the present value of cash flows equal to the purchase price. Cash flows here:
– t0 = −$105 (purchase),
– t1 = +$6,
– t2 = +$106 (final dividend $6 + call price $100).
Solve for r in: −105 + 6/(1+r) + 106/(1+r)^2 = 0.
Algebraic steps:
– Multiply through by (1+r)^2: −105(1+r)^2 + 6(1+r) + 106 = 0
– Expand and rearrange: 105 r^2 + 204 r − 7 = 0
– Use quadratic formula: r = [−204 + sqrt(204^2 + 4·105·7)] / (2·105)
– Compute discriminant: 204^2 + 4·105·7 = 41,616 + 2,940 = 44,556; sqrt ≈ 211.10
– Positive root: r ≈ (−204 + 211.10) / 210 ≈ 0.0338 = 3.38% per year.
So the exact yield‑to‑call ≈ 3.38% p.a., which is slightly higher than the simple average shown above.
Interpretation and practical notes
– Current dividend yield = annual dividend / purchase price = $6 / $105 ≈ 5.71% (income if not called). Yield‑to‑call (~3.38%) is lower because the principal is returned at $100 (below purchase), reducing total return if the issuer calls.
– Yield‑to‑call assumes the issuer calls at the specified date and price. If the issuer does not call, or if you instead convert to common stock, realized return will differ.
– Callable feature reduces upside and can compress returns relative to an uncallable preferred with the same dividend.
– If conversion to common becomes attractive (common price rises enough), you may convert rather than accept the call; most preferreds have conversion terms that govern such situations.
Checklist for evaluating a convertible preferred
1. Read the prospectus for call provisions, call protection period, and call price schedule. (Call protection = a period during which the issuer cannot call the issue.)
2. Compute conversion ratio and conversion value (conversion ratio × common stock price).
3. Calculate conversion premium = (preferred price − conversion value) / conversion value.
4. Compute income metrics: current yield = annual dividend / price.
5. Compute yield‑to‑call and yield‑to-worst (the lowest
5. Compute yield‑to‑call and yield‑to‑worst (the lowest yield you would receive under foreseeable issuer actions, typically the lower of yield‑to‑maturity/hold and yield‑to‑call). Yield‑to‑call (YTC) is the internal rate of return assuming the issuer calls the issue at the stated call date and call price. Formula (solve for y):
P0 = sum_{t=1 to T} D/(1+y)^t + C/(1+y)^T
where P0 = current preferred price, D = annual dividend, T = years until call, C = call price. Solve for y with a financial calculator, Excel (RATE or IRR), or iterative methods.
Worked numeric example — conversion math and yields
– Given: preferred price P0 = $26.00, annual dividend D = $1.50, conversion ratio = 0.40 shares of common per preferred, common stock price = $60.00, callable in 5 years at C = $25.00.
– Conversion value = conversion ratio × common price = 0.40 × $60 = $24.00.
– Conversion premium = (preferred price − conversion value) / conversion value = ($26 − $24) / $24 = 0.0833 = 8.33%.
– Current yield = D / P0 = $1.50 / $26.00 = 0.0577 = 5.77%.
– Yield‑to‑call: solve 26 = sum_{t=1..5} 1.50/(1+y)^t + 25/(1+y)^5. Using trial or Excel, y ≈ 5.05% (the YTC is slightly below the current yield because the call price is lower than the current price).
6. Check dividend characteristics and payment priority
– Cumulative vs noncumulative: Cumulative preferreds accumulate missed dividends; the issuer must pay arrears before common dividends. Noncumulative do not.
– Participating preferred: May receive extra distributions beyond the stated dividend if common dividends reach thresholds.
– Adjustable rate vs fixed rate: Rate resets reduce interest‑rate risk but may alter income profile.
– Define terms in the prospectus and test scenarios where the issuer suspends or skips dividends (how arrears are