financeswag

What are Convertible Preferred Stock Options?

In my FIN727 class, we are studying the case of Corning Inc. and their 1999 case of raising capital for new ventures in the telecommunication sector.  Corning was looking to raise about $5B in capital from this endeavor and were looking at selling convertible bonds to investors in order to cover their costs.

Being a “nube” to almost everything finance-related, I had to do a bit of digging to find a very “simplistic” definition to the term.  Allow me to share my very rudimentary understanding.

Essentially, “convertible stocks” are is preferred stocks that holders can exchange for common stock at a set price after a certain date.

For example, let’s assume you purchase 100 shares of Brace Company convertible preferred stock on March 1, 2012 and according to the registration statement, each share of preferred stock is convertible after January 1st 2013, (the conversion date) to three shares of Brace Company common stock (The number of common shares given for each preferred share is called the conversion ratio. In this example, the ratio is 3.0).
 
If after the conversion date arrives Brace Company preferred shares are trading at $50 per share, and the common shares are trading at $10 per share, then converting the shares would effectively turn $50 worth of stock into only $30 worth (the investor has the choice between holding one share valued at $50 or holding three shares valued at $10 each). The difference between the two amounts, $20, is called the conversion premium (although it is typically expressed as a percentage of the preferred share price; in this case it would be $20/$50, or 40%).
 
By dividing the price of the preferred shares ($50) by the conversion ratio (3), we can determine what the common stock must trade at for you to break even on the conversion. In this case, Brace Company common stock must be trading at a minimum of $16.67 per share for you to seriously consider converting ($50/3 = $16.67).
 
Convertible preferred shares trade like other stocks, but the conversion premium influences their trading prices. The lower the conversion premium, (that is, the closer the preferred shares are to being “in the money”, which Prof. Maxwell explains as being over $0) the more the price of the preferred shares will follow the price movements of the common stock. The higher the conversion premium, the less the convertible preferred shares follow the common stock.

This matters because, like most types of stock, a holder can lay stake to ownership in a company.

The three biggest characteristics of these stocks are:

  1. Rating- Most convertible bonds are rated by one of the bigger standard bearers in the credit rating realm (S&P, Moody’s, etc) and they are rating based upon equity and not debt.  This benefits holders in a number of ways, but the biggest is in terms of tax breaks.
  2. Return- Which is why anyone would invest in anything, but especially this.  Convertible stocks have scheduled fixed dividends that common stock holders do not always see.  They are also usually high prioirty when it comes time to liquidate assets or sell a company/project.
  3. Raise capital- Issuing convertible shares is a good way for companies to raise capital outside of traditional equity financing.  With convertible preferred, a company can secure a lower interest rate than with pure debt financing and use the promise of a dividend to sell shares at a higher price.

In short, convertibles are a good way for a company with poor credit or major debt to find financing on better terms.  The risk is that a individual purchasing these shares has to determine whether the higher yield on these stocks are worth the high chance that they probably will not get their money back.

… Now, I back to the Corning case.  Wish me luck!