Stock Market

Convertible preferred stock offers the owner the option to convert their preferred stake into shares of common stock. The terms of conversion are determined at the time of issuance and are carefully spelled out in the prospectus. Consider the following hypothetical scenario:

To raise capital, my company issued shares of $100 par value, 5 percent convertible preferred stock with the right to convert the security into 4 shares of common stock at $25 per share; at the time, my common stock was trading at $15 per share. By offering you the conversion privilege, I was able to get away with paying you a dividend that most investors would have otherwise rejected as insufficient.

Upon issuance, the conversion privilege has little or no value (why would you convert a $100 preferred stock into 4 shares of common stock, effectively paying $25, when the current market price is only $15?). Instead, you hold your position because you are interested in the $5 annual per share dividend. The potential to profit from a move in the common stock without the associated risk is simply icing on the proverbial cake.

A few years pass and the price of my common stock has increased to $40. Now, the conversion right offers some real gravy! An arbitrager could purchase shares of the preferred stock on the open market, convert them, and instantly experience a profit of $15 per share ($40 per share selling price - $25 per share cost = $15 per share profit). Due to the basic law of supply and demand, the resulting buying frenzy will cause the market price of the preferred stock to rise, say, to $160 per share. Here you are, sitting on your original shares, with a $5 annual dividend arriving in the mail every year and a $60 unrealized capital gain due to the conversion feature. Life is sweet.

There's only one problem. You originally purchased your shares strictly for investment purposesthat is, you wanted current income in the most old-fashion of ways. Your shares, which originally yielded 5 percent ($5 annual dividend divided by $100 per-share market value) now only yield 3.125 percent ($5 dividend divided by $160 market price) thanks to the conversion-driven increase in the market value!

Had you purchased your position before the conversion boom, you would be fine in the event of a collapse in the underlying common stock. Your investment would return to its former price and you would continue to receive your dividend check in the mail. Had you purchased the shares after the price contained some sort of reflection of the conversion privilege, however, you would have effectively been speculating in the common stock! The only redeeming factor is that the presence of the preferred dividend, in most cases, establishes a practical floor that protects you from losing everything.

There are portfolio managers who spend their entire lives specializing in nothing but convertible arbitrage. This is a field dominated by specialists. For those of you who insist on playing in this sandbox, remember that arrogance can be financially ruinous; seek the advice of professionals.