Convertible Securities: A Comprehensive Guide to Types, Features, and Valuation

Convertible Securities: An Overview

Convertible securities are financial instruments that offer investors the flexibility to convert them into a different form or type of security, typically common stock. These securities provide investors with the potential for both fixed income and equity returns.

Types of Convertible Securities

• Convertible Bonds: Bonds that can be exchanged for a predetermined number of shares of common stock.
• Convertible Preferred Stock: Preferred stock that can be converted into common stock.

Key Features of Convertible Securities

• Conversion Ratio: The number of shares of common stock an investor will receive if they exchange their convertible security.
• Conversion Price: The price at which the convertible security can be converted into common stock.
• Conversion Value: The market value of the common stock that the convertible security can be converted into.
• Conversion Premium: The difference between the market price of the convertible security and its conversion value.

Valuation of Convertible Securities

• Pure Bond Value: The value of the convertible security if it were a straight bond without conversion privileges.
• Floor Value: The minimum price at which a convertible security will typically trade, usually equal to its pure bond value.
• Downside Risk: The difference between the market price of the convertible security and its floor value.
• Parity Point: The point at which the pure bond value of the convertible security equals its conversion value.

Other Considerations

• Forced Conversion: Occurs when a company calls a convertible security that has a conversion value greater than the call price.
• Step-up in Conversion Price: A feature that allows the conversion ratio to decline over time, encouraging early conversion.
• Basic EPS: Earnings per share adjusted for dilution, representing net income divided by outstanding shares.
• Diluted EPS: Earnings per share adjusted for all potential dilution from convertible securities and other options.

Warrants

Warrants are options to purchase a specified number of shares of common stock at a specific price over a given time period. They are often attached to debt securities as a financial sweetener to lower the interest rate cost to the corporation.

Valuation of Warrants

• Intrinsic Value: The market value of the common stock minus the exercise price.
• Exercise Price: The price at which the warrant allows the investor to purchase common stock.
• Speculative Premium: The market price of the warrant minus its intrinsic value.

Derivative Securities

Derivative securities derive their value from an underlying security, such as common stock or government bonds. Convertible securities and warrants are examples of derivative securities.