The terms "redeemable shares" and "convertible shares" refer to different types of preferred stock. If a preferred stock is redeemable, it means that the issuing company can exchange those shares for cash, while convertible shares can be exchanged by the shareholder for common stock. Here are the specifics on redeemable and convertible shares.
Redeemable preferred shares
As I said, redeemable shares can be "bought back" by the issuing company at a predetermined price and at or after a predetermined time. There are two main categories of redeemable shares.
If the issuing company is obligated to redeem shares on a certain date, we say that the shares have a maturity date. On the maturity date, the company gives the shareholders the original value of those shares (the par value), and the stock then ceases to exist. If a preferred stock has no maturity date, it is known as perpetual.
Many preferred stocks have a more fluid redemption structure, which is also known as having a call date. The call date is the first date on which the company is allowed to redeem those shares for cash, although it's important to mention that there is no obligation for the company to do so. Generally, the first call date is around five years after the issue date, and is at a call price that's slightly greater than the stock's issue price. If the company can redeem the shares at the call date or any time after, it is called perpetual redeemable preferred stock.
Companies often choose to redeem, or "call," their preferred stocks if current market interest rates are significantly lower than the dividend rate of the outstanding preferred stock. For example, if a company has the ability to redeem its preferred stock that pays a 7% dividend yield and reissue shares that pay a 4% yield, doing so could translate to a major cost savings.
For any redeemable preferred stock, the redemption or call price as well as the date the shares can or will be redeemed can be found in the stock's prospectus.
Convertible preferred shares
This term refers to preferred shares that can be exchanged for common shares in the same company. Preferred shares are usually purchased for their dividends, which remain constant for as long as the stock exists. As a result, there is little chance of upside in the stock price, no matter how well the issuing company is doing.
So, convertible preferred stock allows investors who have a bullish outlook on the underlying company to trade their guaranteed dividends for potential upside in the company's common stock.
As an example, let's say that you have a positive long-term outlook about a certain bank, but you think the banking industry is still years away from meaningful and sustainable growth. So, instead of investing in its common stock, you buy convertible preferred shares that pay you a 6% dividend while you wait. Then, once the bank's common shares start to rise, you can swap your income-generating preferred shares for common shares with virtually unlimited upside potential.
Just as with redeemable shares, you can find the details about convertible preferred stock in its prospectus, including the allowable conversion date(s), and the conversion ratio.
If you're ready to take the next step on your investing journey, we can help. Head on over to our Broker Center, and we'll point you in the right direction with lots of options for getting started.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!