Understanding What Makes Convertible Preferred Stocks Different
Specific Rights for Converting Preferred Stocks
It may seem strange to a new investor that stocks can change in form, but it is important to know that some preferred stocks may contain conversion rights. When this occurs, people on Wall Street refer to these securities as convertible preferred stocks.
How Convertible Preferred Stocks Work
Let’s assume that after reading the terms of a particular security contract, you decided to purchase 100 shares of convertible preferred stock in XYZ Bank. The cost of the preferred shares to you is $500 per share, making your total investment $50,000. The class of preferred stock you bought pays $25 per share annually in dividends, which equates to a dividend yield of 5%. It also comes with a special conversion privilege that states you can convert each preferred share into 50 shares of common stock.
The Nature of the Deal
Think about that for a moment. Your preferred shares worth $500 each pay you $25 annually in dividends, or a yield of 5%. You also get an additional benefit that allows you to trade your preferred shares and exchange them for 50 shares of common stock. This means that the “cost” to convert to common stock is $10 per share (the $500 preferred shares divided by the 50 common shares equals $10 per share in the event of conversion). This can be a very useful tool if utilized well.
When to Hold Your Preferred Shares
If you woke up one morning and found that the common shares were $7, this would not be the right time to use the conversion privilege. Remember, each preferred share can be exchanged for 50 common shares, or 100 preferred shares × 50 common shares = 5,000 common shares. If you decided to exchange your 100 preferred shares, you would end up with 5,000 common shares at $7 per share, totaling $35,000. So when compared to the amount you paid initially ($50,000), you would be facing a loss of $15,000. To make matters worse, you would no longer receive dividends from your preferred shares.
When to Convert to Common Shares
Now, let’s suppose XYZ Bank releases important news, and the common shares rise to $30 each. This would be the right time to take your 100 preferred shares and convert them into 50 common shares, giving you a total of 5,000 common shares. You could quickly sell your common shares for $150,000 ($30 per share × 5,000 shares = $150,000).
Your cost was only $50,000 when you initially purchased the shares, so you effectively doubled your money. You also managed to collect dividends up until the time you exercised your conversion rights.
It is easy to see why it is important to understand the terms of your convertible preferred stocks. You can also see why many people prefer this class of stock over common stock. It allows for a level of control for the shareholder (instead of relying entirely on market forces) and can be used to achieve significant profits.
Sources:
- U.S. Securities and Exchange Commission. “Convertible Securities”.
- Gabelli Funds. “A Review of the Convertible Securities Market”.
- Ben Dickinson. “The Basic Conversion Rights of Mandatory Convertible Preferred Stocks”. Tennessee Business Law Journal.
- Sara Swami. “Preferred Stocks”. Chapter 15. Financial Markets: The Evolution of the Financial System. John Wiley & Sons, 2017.
Source: https://www.thebalancemoney.com/convertible-preferred-stock-for-beginners-357976
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