Definition of a Convertible
A convertible security is a corporate bond or preferred stock with an embedded option that allows the holder to “convert” the bond or preferred stock into a fixed number of common shares of the issuing company.
Like other corporate bonds and preferred stocks, convertible securities pay a fixed rate and convertible bonds have a maturity date.
Convertibles have the added feature of allowing the holder to convert the security into common stock.
Convertibles Derive Value from Two Sources
- The conversion value is the value of the common shares if the bond were converted today.
- Convertibles participate in upside appreciation of the underlying stock because of the conversion feature.
- The investment value is the value of the security if it were a straight bond without a conversion feature.
- Convertibles also provide a downside cushion because an investor can continue to collect the interest and principle if the stock declines.