Convertible preferred stock

Convertible preferred stock is preferred stock that the holder can exchange for a preset number of the issuer's common shares. It combines the steady, fixed dividend of preferred stock with an equity kicker: if the common stock appreciates enough, the holder can convert and capture that upside.

The number of common shares received per preferred share is the conversion ratio, set when the stock is issued. It equals par value divided by the conversion price. A $100 par convertible preferred with a $25 conversion price has a conversion ratio of 4 — each preferred share converts into 4 common shares. A useful checkpoint is parity: the price at which the preferred and the underlying common are worth the same. If the preferred trades at $110, parity for the common is $110 ÷ 4 = $27.50; if the common trades above parity, converting is profitable.

The conversion feature is valuable, so investors pay for it: convertible preferred typically carries a lower dividend rate than an otherwise identical non-convertible (straight) preferred. The convertible's market price also tends to track the common stock more closely once the common approaches the conversion price, making it less purely rate-sensitive than straight preferred. Conversion ratios are usually protected against dilution, adjusting for stock splits and stock dividends.

Convertible securities appear regularly on the Series 7, Series 65, and Series 66 exams. Be ready to compute the conversion ratio from par and conversion price, find parity prices, and explain why convertible preferred offers a lower yield than straight preferred.