Many investors like the idea of an investment that provides current income and growth potential. Convertible preferred stock gives investors both of those, combining dividends that are often higher than the company's common shares pay and the opportunity to benefit from any share-price appreciation in the common stock. Convertible preferred stock does this through its conversion feature, which allows shareholders to convert their preferred stock into a predetermined number of shares of common stock under certain conditions. The specific ratio of common shares to preferred shares on conversion is an important factor in valuing the preferred stock, and the potential upside is much larger than what you'd get with traditional preferred stock.
Why conversion matters
Most investors think of preferred stock as a substitute for a fixed-income investment like a bond. Preferred stock is technically stock in a company's capital structure, but it has many features of a bond. Its dividend rate is typically fixed in advance, and companies retain the right to redeem preferred stock at a predetermined price either on a specific date or at the company's election. Because the fixed dividend resembles interest, and the redemption feature resembles a maturity payment, preferred stock is seen as more similar to a bond investment than to common stock.
Yet the conversion feature changes the nature of preferred stock. By tying the value of the preferred shares to the value of the common shares, convertible preferred stock has two different factors affecting its share price. When the common stock trades well below the effective conversion price of the preferred, then the convertible preferred stock will usually see its price move in tandem with the bond market. Yet when the common stock's value rises high enough that it makes sense for preferred shareholders to convert their preferred holdings to common shares, then the convertible preferred stock will trade in line with movements in the common stock.
Why convertible preferred stock is more convenient than convertible bonds
Convertible preferred stock has a lot in common with convertible bonds, but there's one big advantage: Convertible preferred stock frequently trades on major stock exchanges, making transactions easy to conduct. By contrast, convertible bond markets can be much less liquid, and finding trading counterparties is more of a hassle for the average investor.
If you're interested in investing in a company but want to get more income than you'd earn in dividends from its common stock, take a look to see if it offers convertible preferred shares. If it does, the regular income and growth potential might be exactly the mix you want for your portfolio.
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!