Convertible security

A convertible security is a security— usually a bond or a preferred stock— that can be converted into a different security—typically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs.

Companies generally issue convertible securities to raise money. Companies that have access to conventional means of raising capital, such as public offerings and bank financings, might offer convertible securities for particular business reasons. Companies that may be unable to tap conventional sources of funding sometimes offer convertible securities as a way to raise money more quickly.

In a conventional convertible security financing, the conversion formula is generally fixed - meaning that the convertible security converts into common stock based on a fixed price. The convertible security financing arrangements might also include caps or other provisions to limit dilution (the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock).

Risk
The most common issuers of both convertible bonds and convertible preferreds are non-investment-grade-rated companies. The convertible securities may be nonrated or rated below BBB– from the major rating agencies, such as Moody's or Standard & Poor's. An interesting point to note is that most companies that issue convertibles don't default on their obligations, but credit analysis of each issuer is important because there is that risk.

Convertible bond risks are discussed in more detail here.

Convertible preferred shares are usually issued by financial companies to bolster capital ratios for regulatory reasons. They generally are not redeemable, i.e. they have no time limit. They are significantly riskier than convertible bonds given that:


 * they tend to have no time limit, so what sets the price is the general level in interest rates, and the credit risk of the particular issuer
 * they rank behind debt as priority in a liquidation or sale of the business, therefore they have higher credit risk

Accordingly the Vanguard Fund (VCVSX) below, for example, is heavily weighted towards convertible bonds which are lower risk. In both cases, it underlines the need for specialist expertise to determine if the "call" option awarded to the investor (the right to convert into common stock) is correctly valued.

Convertible preferred stocks
Convertible preferred stock is a stock which carries a right to convert into common stock at a certain pre-specified exercise (or strike) price. The analysis of the value of this option (effectively a long dated call option) to the investor is complex and it is a relatively risky area that requires expertise to make successful investments.

Unlike convertible bonds, convertible preferreds lack a maturity date -- unless they are redeemable and a date is specified at issue. Convertible preferreds have greater equity upside potential than straight preferreds, but normally lower starting yields and greater volatility.

Convertible securities funds
Below are two example funds which are composed primarily of convertible preferred stocks and bonds.
 * Fidelity Convertible Securities Fund (FCVSX), which tracks the Bank of America Merrill Lynch All U.S. Convertibles Index.
 * Vanguard Convertible Securities Fund (VCVSX), which tracks a Spliced Convertibles Composite Index consisting of 70% Bank of America Merrill Lynch All US Convertibles Index and 30% Bank of America Merrill Lynch Global 300 Convertibles ex-US Index (hedged)

Forum discussions

 * Can you talk me out of Preferred Stocks?
 * I don't understand Convertible Securities
 * Wiki - Convertible Securities

Fund information

 * Fidelity ® Convertible Securities Fund (FCVSX)
 * Vanguard Convertible Securities Fund (VCVSX), for individual investors
 * Vanguard Convertible Securities Fund (VCVSX), for financial advisors