Securities

As the name suggests, the convertible bonds and convertible preferred (or convertibles, in short) are securities that offer the holder the option of converting them into or exchanging with a predetermined number of common shares in the issuing company. They are hybrid securities that demonstrated the features of both equity and bond. Convertibles are issued by a company (also referred to as borrower) when a lower interest rate or dividend is desired and the issuer is willing to suffer the potential dilution of the investor converting the hybrid into common equity of the issuing company. Also, refer my article Equity: Common Stock, Preferred Stock and Convertible Preferred here.

Historically, the interest rates or dividend rates on convertibles have been lower than that of a similar non-convertible debt. The investor funds the company with the believe that the value of the underlying stock, into which the debt will convert, will grow over a period of time to an amount that exceeds a market rate of return for the instrument. In other words, the investor receives the potential upside of the conversion into common equity while protecting the downside with cash flow from the interest payments and the return of principal amount at maturity. However, if the stock delivers an under performance, the conversion does not make sense and the investor is stuck with a sub-par bond rate.

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A company’s equity capital is represented by common stock or preferred stock. A company can be capitalized with only common stock, but usually preferred stock is issued along with common stock. Both common and preferred stocks are entitled to receiving dividends, but where both of them are outstanding, preferred stock holders enjoy priority. Let’s understand the concept in detail.

Common Stock

Common stock is a type of equity security that represents an ownership in a company. It can be classified into voting shares and non-voting shares. The holder of a voting stock carries a voting right to elect Directors of the company and to vote company’s fundamental corporate activities (including M&A) and policies. A non-voting stock, on the other hand, has all the financial rights of the common stock, but is devoid of the power to choose directors or veto corporate transactions.

During liquidation, the common shareholders are entitled to receive residual claim on the company’s assets that is, they stand at the last behind all the corporate creditors and preferred shareholders for receiving the payment. When a company is forced into bankruptcy because of its inability to pay its obligations (debts), the common shareholders receive nothing. So, their returns are uncertain, contingent to earnings, company reinvestment, market efficiency and stock sale. Since their investment risk is high, common stockholders enjoy higher returns (with higher capital appreciation) compared to preferred stockholders when the company does well.

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Hybrid Security: Convertible Bonds and Convertible Preferred

Equity: Common Stock, Preferred Stock and Participating Preferred