Is Convertible Preferred Stock a Smarter Way to Invest?

Is Convertible Preferred Stock a Smarter Way to Invest?

Being a beginner in investment I am always looking for safe and secure options to help my savings grow. As I am a averse to taking risk I avoid investing in risky stocks. On the contrary, I prefer investing in such options which guarantee a moderate and safe return. This article discusses whether convertible preferred stock is the best option or not.
WealthHow Staff
Last Updated: Oct 6, 2017
Being an overcautious investor doesn't work in your favor. Simply by saving money in bank which will pay you a low interest will not help in your future plans. It's need of the hour to take risks in the stock market and maximize your return on investment. Preferred stock is one way where you can invest in the company and be assured that your money will not disappear but will grow at a fixed rate. In broader terms, preferred stock is that part of share capital where the company enjoys preferential rights as payment of dividend at a fixed rate and return of capital on winding up of the company. Preferred stock is further subdivided into many categories such as redeemable, participating, convertible and cumulative.

Definition of Convertible Preferred Stock

Financial analysts have always termed convertible preferred stock as a mix of debt and equity. These stocks enjoy an upper hand in terms of dividends which are fixed and the shareholders receive their investment prior to common stock shareholders. The disadvantage which it suffers is that bondholders are paid prior to these preference stockholders. Still many companies prefer issuing preference shares as the shareholders cannot vote in the annual general meeting. The convertibility factor works well in favor of investors when the equity market is strong and preference shareholders have chances of getting more return than their usual fixed dividend.

Benefits of Convertible Preferred Stock

The convertible preference shares are categorized into mandatory and traditional preferred stock. Mandatory stocks have a fixed date of converting it into a share. These shares will be automatically converted into common stock which may not be beneficial to the investor depending on the time at which it is converted. The traditionally preferred shares, on the other hand, are convertible at the holder's choice. Here the main advantage which the holder enjoys is that he can convert the stock when the common stock's value is more than the convertible preferred stock. According to some investors, investing in convertible preferred for an individual might be difficult as the after tax dividend earned by the investor is less as compared to other stocks. It might be beneficial if the equity market of that company has experienced an exponential rise in the prices and the holder of these shares can convert and earn profit.

According to financial analysts, many convertible preferred stocks are eligible for a higher tax rate for individual investors. The corporate on the other hand, have to pay comparatively lower taxes which benefits them to hold convertible shares of other companies. If you want to invest in preferred stock, it's always wise to talk to a financial planner and discuss strategies of investment. In order to buy preference shares, it's important to study the financial ratios namely debt equity ratio which helps you understand the company's financial health. Debt equity ratio examines the relationship between total debt contributed by creditors and total equity contributed by shareholders. As preferred stocks are considered as debt, many investors prefer low ratio as these indicate safe return of their money.

It's important from an investor's point of view to understand whether the shares are going to be converted as per fixed price or these will be subject to market price fluctuations. Also, as an investor do calculate the conversion ratio which is par value divided by conversion price of the equity. Some analysts caution the investor to minimize their investment in these stocks as the returns are less than common stock and the company can decide to skip dividend for a particular year if they suffer loss. Even these shares are subject to high volatility due to interest rate fluctuations.

Summarizing this discussion, convertible preferred stocks are an ideal option if you earn a conversion premium and are able to understand the trends of the financial market. Conversion premium is basically the difference between the market value of converted shares and market value of unconverted shares. If you earn a higher premium then convertible preference shares is an ideal option which will guarantee you safe return of your investment.