Convertible securities

Definition

Convertible securities are financial instruments, typically bonds or preferred stock, that can be converted into a predetermined number of shares of common stock at the discretion of the holder. This feature allows investors to benefit from potential upside in the company's stock price while providing a level of income or security through the bond or preferred stock until conversion occurs.

5 Must Know Facts For Your Next Test

1. Convertible securities often have lower interest rates compared to traditional bonds because they offer the added benefit of potential equity conversion.
2. The conversion ratio, which determines how many shares can be obtained per convertible security, is an important factor for investors considering conversion.
3. When convertible securities are converted into common stock, it can lead to dilution for existing shareholders since more shares are added to the total outstanding shares.
4. Companies may issue convertible securities as a way to raise capital without immediately diluting equity ownership.
5. The accounting treatment for convertible securities varies based on their classification and whether they are accounted for as debt or equity.

Review Questions

• How do convertible securities influence a company's capital structure and investment strategy?
  • Convertible securities can significantly influence a company's capital structure by providing a hybrid financing option that combines features of both debt and equity. Companies may use these instruments to attract investors seeking fixed income while also allowing them to convert to equity if the company's stock performs well. This strategy can help companies raise capital while delaying dilution until the conversion occurs, providing flexibility in managing their financial resources.
• Discuss how the conversion feature of convertible securities impacts earnings per share (EPS) calculations and investor perceptions.
  • The conversion feature of convertible securities impacts EPS calculations by potentially increasing the number of shares outstanding when conversions take place. This increase can lead to dilution, which affects both basic and diluted EPS figures. Investors pay close attention to these changes as they assess the company’s profitability and growth potential, often leading to different perceptions based on how management communicates the implications of potential conversions.
• Evaluate the risks and benefits associated with investing in convertible securities compared to traditional debt or equity investments.
  • Investing in convertible securities presents a unique blend of risks and benefits compared to traditional debt or equity. On one hand, they provide downside protection due to their bond-like nature while offering upside potential through conversion to equity if the company performs well. However, investors face risks such as potential dilution of ownership and market volatility affecting the underlying stock price. Analyzing these factors allows investors to weigh whether convertible securities fit their investment goals and risk tolerance effectively.

Related terms

Equity: Equity represents ownership interest in a company, typically in the form of common or preferred stock.

Dilution: Dilution occurs when the issuance of additional shares, such as through the conversion of convertible securities, reduces existing shareholders' ownership percentage in the company.

Warrants: Warrants are financial derivatives that give the holder the right to purchase shares of stock at a specified price before a certain expiration date, similar to convertible securities but typically issued separately.