A convertible issue is a bond or preferred stock that can be exchanged for another security, usually the common stock of the issuing company. Convertible preferred stocks and convertible bonds (or debentures) are basically alike with the exception that preferred stocks represent equity in a company whereas bonds represent debt. Generally, no payment is required to effect conversion other than the surrender of the bond or the preferred stock. The conversion privilege normally lasts for the life of the bond, or for the life of the preferred stock, although in a few instances, the number of shares of common stock for which the convertible can be exchanged may change during the life of the convertible.
Convertible bonds and stocks are usually sold by corporations when other means of raising money would be more expensive. The conversion feature is a “sweetener” to persuade investors to accept a rate of interest on a bond or preferred stock that is below prevailing levels. If the stock rises in value, the value of the convertible will rise with it.
A convertible’s value is drawn both from its conversion privilege (thus, on the price of the underlying stock), and from the value it commands simply because it’s a bond or a preferred stock. While its price rises with its conversion value (i.e., with a rise in the stock price), its price will normally fall no lower than its investment value. Most often, however, convertibles sell at premiums above both their conversion and investment values. (When you can buy a convertible issue at its investment value, you get the conversion privilege free of charge. By the same token, when you can buy a convertible at its conversion value, you get the investment feature—better quality and generally higher income—free of charge as a sort of bonus.