Definition of Convertible Securities
Convertible securities are financial instruments, such as bonds or preferred stock, that can be exchanged for a predetermined number of another form of security, usually common stock, at certain times during the holder’s life. Typically, this conversion feature is at the discretion of the security holder and is done under pre-established conditions.
Examples
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Convertible Bond: A bond issued by a company that can be converted into a predefined number of its shares at the discretion of the bondholder. For instance, a $1,000 convertible bond might be convertible into 20 shares of the issuing company’s stock.
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Convertible Preferred Stock: Preferred shares that can be converted into a specified number of common shares. For example, a corporation might issue convertible preferred stock that can be exchanged for common shares at a 1:1 ratio.
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Government Convertible Security: A government bond in which the holder has the right to convert the holding into new stock instead of obtaining repayment. For instance, a government could issue a 10-year convertible security that can be converted into government shares after five years under certain market conditions.
Frequently Asked Questions
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Q: What are the advantages of convertible securities for investors?
A: Convertible securities offer investors the potential for upside participation in the equity markets (through conversion to common stock) along with the fixed-income characteristics of bonds or preferred stock.
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Q: How do companies benefit from issuing convertible securities?
A: Companies benefit because convertible securities can offer lower interest rates compared to non-convertibles due to the added conversion feature and can help delay equity dilution.
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Q: What are the risks associated with convertible bonds?
A: The primary risks include interest rate risk, credit risk, and the risk that the underlying stock does not perform well enough to make conversion attractive.
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Q: When is it advantageous for an investor to convert their convertible securities?
A: It is advantageous if the market price of the common stock exceeds the conversion price, making the conversion valuable and beneficial.
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Q: What is meant by the conversion ratio?
A: The conversion ratio is the number of common shares that can be obtained for each convertible bond or preferred share. It is defined at the time of issue.
- Compound Instrument: A financial instrument that comprises both a liability and an equity component. Convertible securities are classic examples of compound instruments.
- Equity: Ownership interest in a company, usually in the form of common or preferred stock.
- Debt Security: A financial instrument representing a loan made by an investor to an issuer (such as a bond), characterized by regular interest payments and the return of principal.
- Preferred Stock: A class of ownership in a corporation with a fixed dividend, receiving priority over common stocks in the payment of dividends and upon liquidation.
- Convertible Arbitrage: A trading strategy that typically involves taking long positions in convertible securities and short positions in the underlying common stocks.
Online References
Suggested Books for Further Studies
- “Convertible Securities: The Latest Developments for Cost-Effective Financing” by John M. Marshall
- “Convertible Bond Markets” by Jens H. E. Christensen
- “Convertible Bonds: Risk Management, Analysis, and Structuring” by Kevin B. Connolly
Accounting Basics: “Convertible Securities” Fundamentals Quiz
### What characteristic makes convertible securities attractive to investors?
- [ ] They always offer higher returns than other securities.
- [x] They provide the potential for future equity conversion.
- [ ] They are only issued by government entities.
- [ ] They never carry any risk.
> **Explanation:** Convertible securities are attractive because they offer the potential for future equity conversion, allowing investors to benefit from the potential upsides in the stock market.
### What is a convertible bond?
- [x] A bond that can be converted into a pre-determined number of shares.
- [ ] A bond that pays dividends.
- [ ] A bond issued only by the government.
- [ ] A corporate bond with no conversion option.
> **Explanation:** A convertible bond is a bond issued by a company that can be converted into a pre-defined number of its shares at the discretion of the bondholder.
### What does the conversion ratio of a convertible security indicate?
- [ ] The interest rate of the security.
- [ ] The repayment time of the bond.
- [x] The number of common shares received upon conversion.
- [ ] The credit rating of the security.
> **Explanation:** The conversion ratio indicates the number of common shares an investor receives upon converting each convertible bond or preferred share.
### Why might a corporation issue convertible securities?
- [ ] To avoid equity dilution altogether.
- [ ] To increase immediate stock value.
- [ ] To take advantage of tax benefits.
- [x] To attract investment with lower interest rates and delay equity dilution.
> **Explanation:** Corporations issue convertible securities as they can offer lower interest costs and have the potential to delay equity dilution.
### Which type of security is NOT typically classified as a convertible security?
- [ ] Convertible bond
- [ ] Convertible preferred stock
- [x] Common stock
- [ ] Government convertible security
> **Explanation:** Common stock is not typically classified as a convertible security, as it does not typically have conversion features into other types of securities.
### What is convertible arbitrage?
- [ ] A feature of convertible preferred stock.
- [x] A trading strategy involving long positions in convertible securities and short positions in the underlying stocks.
- [ ] A type of risk-free bond.
- [ ] A government-issued convertible bond.
> **Explanation:** Convertible arbitrage is a trading strategy that involves taking long positions in convertible securities and short positions in the underlying common stocks.
### When does it usually make sense for an investor to convert a convertible bond into stock?
- [ ] When interest rates are high.
- [x] When the market price of the stock exceeds the conversion price.
- [ ] When the company is about to go bankrupt.
- [ ] When the bond yields zero interest.
> **Explanation:** It usually makes sense to convert a convertible bond into stock when the market price of the common stock exceeds the conversion price, making the conversion beneficial to the investor.
### What primary risk is associated with convertible bonds?
- [ ] They always guarantee returns.
- [ ] They cannot be sold before maturity.
- [x] The underlying stock may not perform well enough.
- [ ] They carry no credit risk.
> **Explanation:** The primary risk associated with convertible bonds is that the underlying stock may not perform well enough to make conversion attractive.
### Convertible bonds typically offer interest rates that are ____ compared to similar non-convertibles.
- [ ] Higher
- [ ] Same
- [x] Lower
- [ ] Much higher
> **Explanation:** Convertible bonds typically offer lower interest rates compared to similar non-convertible bonds due to their added conversion feature.
### What is a compound instrument?
- [x] A financial instrument that combines both equity and debt features.
- [ ] A fixed-income security.
- [ ] A government-issued bond.
- [ ] An instrument with no conversion features.
> **Explanation:** A compound instrument is a financial instrument that combines both equity and debt features, such as convertible securities.
Thank you for engaging with this comprehensive study of convertible securities. Your deepening knowledge in financial instruments will aid your journey in accounting and investment strategies!
