Convertible securities, also called hybrid securities, are a special subset of securities.
The most common forms of hybrid securities are convertible bonds and convertible preferred stocks. These are interest-paying instruments issued by companies that later can be converted into shares of the common stock of the same company.
This allows investors to take advantage of a rising share price while enjoying the relative security of a bond. On the downside, convertible securities, by and large, have a lower coupon rate than regular corporate bonds, leaving you with relatively poor returns if the share price fails to rise sufficiently to make a conversion worthwhile.
Some of these assets can be converted before their due date and others give the company the option to forcibly convert if the common stock reaches a pre-determined price.
The conversion formula is almost always fixed - meaning that the convertible security converts into common stock based on a fixed price. Upon issuing these convertibles, companies usually determine this fixed price above the current price of their stock. This way, the convertible security acts a bit like an option for investors.
How hybrid securities work in practice
Let's take company ABC that issues a convertible bond with a conversion price of $100, while its shares trade around $50. This hybrid security acts much like a bond because chances are low that it will ever hit $100+. Fast forward a few months or years and suddenly ABC announces a fancy new product that propels the share price north of $120. Now suddenly, the hybrid security is “in the money” and starts to act much like common stock. Regular interest payment can be considered peanuts compared to the juicy $20+ premium investors can expect when they convert their bond holdings to common stock at $100.
Advantages, disadvantages, and risks of convertibles
To understand the full picture, we need to see why companies would want to issue convertible securities. After that, we can see why investors would want to buy them.
To fund new projects, companies can raise money through issuing new stock, bonds or convertibles. By issuing new stock, they dilute their existing shares, which could weigh on the stock price and sentiment. By issuing convertible bonds, the company will offer a lower yield for investors than what they’d need to pay for a regular bond. However, share dilution only happens in the future, should the holders of the hybrid security exercise their right to convert to equity.
Now, why would you want to invest in these convertible securities? Well, investors stand to lose very little if anything by holding these assets. Risks are kept in check (unless the company goes bankrupt), while you can have a reasonable upside if the company’s stock price does well. While most online brokerages offer to trade traditional common stock, the possibility of trading hybrid securities like convertible bonds or convertible preferred shares is oftentimes missing.
We recommend sticking to the best online brokers that usually list these securities as well.