Convertible shares are one of the most widely used investment instruments. If you are looking at investment options, this article will help you in learning about how convertible preference shares work and the advantages and disadvantages associated with it.
Convertible preference shares can be addressed as an investment that will act as a hedging tool in case the shares you have invested in, do not give you profits. It is a more secured investment than investing in equity debt financing.
What is Convertible Preference Share?
Convertible preference share is a share that gives its investors the option to convert his Preference Shares into Ordinary Equity Shares. However, this option can be availed only after a prescribed period. The shareholder gets his dividend at a fixed rate and investors invest in them as fixed income securities.
How Does it Benefit?
Convertible preferences shares are a good source of fixed income. After a specific period, investors are legible to convert their preference shares into equity shares. This attracts the investors by giving them an opportunity to profit from the rise in the price of the share. Convertible preference shares are suitable for those investors who have the interest in participating in the growth of the company. It works as a tool of hedging against the fall in the price of the preference share.
How Does it Work?
To understand how the conversion will really work, we’ll work it through an example. Let’s say Adam bought 100 convertible preference shares of Xyz company on 24th August, 2009. Now as per the company’s norms, Adam can covert his Preference shares into Equity shares only after the 24th February, 2011. He can convert his one preference share for 4 Ordinary Shares. Therefore, the ‘conversion ratio’ for this would be 1:4. Let’s assume the price of a convertible preference share to be $100 and the price of the equity share to be $20 per share. If Adam opts to convert his Preference Shares to Equity Shares, he will be giving up a share worth $100 for 4 equity shares of $80. Therefore, he’s facing a loss of $20, which is equal to 20%. This loss or difference is called the ‘conversion premium’.
Now divide the price of the preference share with the conversion ratio i.e 100*1/4. This is done to determine the minimum amount you can trade at, to break even the cost incurred. In this case, you can consider converting your shares only if the Xyz company is trading equity shares at a minimum of $25, per share. Anything above the $25 per share mark, you should consider converting your shares. It can be safely inferred that, if the conversion premium is high, convertible preference shares become less attractive and vice versa.
Advantages of converting the convertible preference shares are listed as follows.
- You can gain profit by converting the preference shares into Ordinary Equity shares, if the price of the equity share is high.
- After the conversion you’ll be entitled to all the beneficiary rights that the equity shareholders have. You will be able to be a part of the company’s decision-making by casting votes during shareholder’s meetings.
Disadvantages of converting the convertible preference shares are listed as follows.
- An investor loses the preference of being paid before the equity holders, in case the company liquidates.
- An investor also loses his fixed return in the form of a dividend and may or may not get any returns after conversion, depending on the company’s profit.
Why do Companies Issue Convertible Preference Shares?
Issuing convertible preference shares is a better way for a company to raise capital than the method of equity debt financing. These shares are normally issued by companies either when their ‘stock prices are low’, or when they have been ‘poorly rated’ by credit agencies, or when the company is not able to obtain loans at affordable interest rates. A company can therefore, obtain finance at a lower interest rate by offering fixed income in the form of dividends along with the convertibility option to the investors. The company can also make the conversion of the shares compulsory, so read the investment brochures thoroughly before investing.
Convertible preference shares can be a good a way for gaining steady income and can prove to be a better investment option among other types of preference shares. However, before you choose to invest in convertible preference shares, you need to look out for how the stocks are rated by the major rating agencies like Moody’s and S&P. If the stock is rated poorly or it is rated by small or infamous credit-rating agencies then you should infer that, the stock probably wasn’t able to obtain a good rating from the major rating agencies. Investing in a convertible preference share will certainly lower your risk compared to investing in equity investment.
Disclaimer: Investing in shares is subject to market risk. Please read the offer documents carefully before investing.