Convertible preferred stock is a type of preferred stock which can be converted into equity by the holder, such as common stock. It is a hybrid investment option that provides both dividend income and the potential for capital appreciation.
Convertible preferred stock ranks senior to common stock, but junior to any other class of preferred stock. As with other preferred stock, convertible preferred shares typically pay dividends at a fixed rate, but the dividends are subject to deferral or even elimination if the board of directors determines that paying the dividends is not in the best interests of the company.
The holder of a convertible preferred stock has the option to convert their shares into an equivalent number of common shares. The conversion ratio, also known as the conversion rate, is typically established when the convertible preferred stock is issued and may vary from issue to issue.
When the share price of the common stock is greater than the conversion price, then the holder may benefit from converting their shares into common stock. For example, if the conversion ratio is three-to-one and the price of the common stock is higher than the price of the convertible preferred stock, then the holder will receive three shares of common stock for every one share of convertible preferred stock that is converted. Thus, the holder may benefit from the increase in price of the common stock.
Alternatively, holders of convertible preferred stock may benefit from dividend payments, since the convertible preferred stock pays dividends at a higher rate than common stock. Thus, it is an attractive investment option for income-oriented investors.
Unlike other types of preferred stock, convertible preferred stock provides holders with the chance to benefit from the potential appreciation of the common stock and the dividend payments of the convertible preferred stock. Thus, it is a popular investment among both institutional and individual investors.
Convertible preferred stock does have some risks. First, the conversion option is subject to certain restrictions, such as lockup periods where the holder may not be able to convert their shares. Second, the conversion ratio may be set in favor of the issuing company, resulting in the holder receiving less than the market value of the shares being converted. Finally, the company issuing the convertible preferred stock may opt to not pay dividends to holders if it is in their best interest.
Despite the risks, convertible preferred stock provides investors with the chance to benefit from two different types of returns: dividends and capital appreciation. As such, it is an attractive option for investors seeking income and the potential to capitalize on a company’s growth potential.
