Monday, August 31, 2009

Convertible securities

Another factor which affects relative rates of returns on different securities is convertibility. Convertible securities consist of special issues of corporate bonds or preferred stock which entitle the holder to exchange these securities for a specific number of shares of the issuing firm‘s common stock. Convertible are frequently called " hybrid securities" because they offer the investor the prospect of both stable income in the form of interest or dividends plus capital gains on common stock, once conversion takes place. The timing of a conversion is purely at the option of the investor; however, the contract agreed to at time of purchase specifies the terms under which conversion may take place. An issuing firm often can "force" conversion of its securities by bringing about a rise in the price of its common stock, because conversion is most likely to occur in a rising market. Conversion is a one-way transaction-once convertibles are exchanged for common stock there is no way back for the investor.
Investors generally pay a premium for convertible securities over nonconvertible securities in the form of a higher price and reduced yield. Thus, convertibles will carry a lower rate of return than other securities of comparable quality and maturity issued by the same company. This occurs because the investor in convertibles is granted a hedge against future risk. If security prices fall, the investor still earns a fixed rate of return in the form of interest income from a convertible bond or dividend income from each share of convertible preferred stock. On the other hand, if stock prices rise, the investor can exercise the conversion option and share in any capital gains earned on the company‘s common stock.

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