What are Convertible Securities?

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Types and Components of Convertible Securities

The different types of convertible securities

#1 – Convertible Bonds

Convertible bonds are those that convert into a fixed number of shares of the issuing company, usually at the time of their maturity. Thus, such bondsSuch BondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more have features of equity as well as debt.

#2 – Convertible Preferred Stocks

Preferred stocksPreferred StocksA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more are those kinds of common shares that get preference over equity shareholders, and convertible preference shares are those who are paid a dividend at a fixed price or a percentage and which get preference over the common equity shares at the time of liquidation. They are convertible in nature in the sense that preference shares can be converted into common equity shares as per the terms and agreement and the nature of the instrument, which is issued by the company.

Convertible Securities Calculation with Examples

Let’s see some simple to advanced examples of convertible security to understand it better.

Example 1

Company XYZ is engaged in the service industry and has a $1,000 par value bond, which is convertible into common stock. It has a coupon rate of 5%, which is paid annually. The bond prospectus specifies a conversion ratio of 30. How many shares will a shareholder get if he has invested $1,000 in the company?

Solution:

The conversion ratio is given in the problem, which is 30, which means that the investor will get 30% worth of shares in proportion to his shareholding of the bonds.

So the problem can be solved with the following steps:

Worth of common shares that the investor will get = $1,000 / 30 = $ 33.34

Example 2

Dilip Buildcon is engaged in the construction industry and has a growing presence in the markets of the middle east and northern Africa. The company has a $3,000 par value bond, which is convertible into common stock. It has a coupon rate of 5%, which is paid annually. The bond prospectus specifies a conversion ratio of 50. How many shares will a shareholder get if he has invested $3,000 in the company?

The conversion ratio is given in the problem, which is 30, which means that the investor will get 50% worth of shares in proportion to his shareholding of the bonds.

Worth of common shares that the investor will get = $3,000 / 50 = $ 1,500

Advantages

  • It gives an advantage to the investor, which converts the risk of security from one instrument into another. For example, if the investor has a bond and it is convertible into equity security, then the investor is into a better position to earn a return on its investments.It also gives flexible options for lower interest payments in case it is convertible into common shares and has lesser maturity tenure.Tax advantagesTax AdvantagesTax Advantage are the types of investments or saving plans that benefit tax exemption, deferred tax, and other tax benefits. Examples include Government bonds, Annuities, Retirement Plans. read more are also there in the case of convertible securities.

Disadvantages

  • One disadvantage is that financing with convertible securities runs the risk of diluting not only the EPS of the company’s common stockEPS Of The Company’s Common StockEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more but also the control of the company. Hence the investment banker who is running the issue faces a hard time to raise money from the banks for the company.Conversion of securities into common equity also has the risk of voting rights as it leads to a dilution of voting rights among a larger group of shareholders, which in turn results in dis-ownership of the founders of the company.

Conclusion

Convertible Securities are financial instruments that can be converted into different securities that have a different nature or working or different terms for redemption. Basically, it takes the form of a different type of security after the term of conversion is ended. The term and the obligation of both the parties, i.e., shareholders and the company, are changed after the security is converted into a different financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more.

There are pros and cons to the use of convertible security for financing; investors should consider what the issue means from a corporate standpoint before buying in. Also, they should consider the financial situation of the company before going for a subscription of a convertible security. Investors should thoroughly review the bond prospectus before investing.

This has been a guide to what are Convertible Securities and its definition. Here we discuss the types of convertible securities along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –

  • Par Value of Share DefinitionContingent SharesStock DilutionFloating Stock