Convertible preferred stock is a hybrid investment security. It combines the fixed-income properties of preferred stock with the option to convert the shares into common stock equity. Convertible preferred shares offer investors the potential to earn a higher total return than other fixed-income securities, with less risk than a common stock investment. Learn about convertible preferred stock, how it works, why an investor would choose convertible preferred stock, and an example.

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What is convertible preferred stock?

What is convertible preferred stock?

Convertible preferred stock is a type of preferred stock. It has the same two main features as a preferred stock investment:

  • Fixed income payment: Preferred shares make regular dividend payments to investors.
  • Preferential treatment: They have a higher ranking in the capital structure over common stock. If the issuing company goes bankrupt, the preferred stock has a higher claim on the company's assets than the common stock (though lower than creditors like debt investors).

In addition, convertible preferred stock has an added bonus. The holder has the option to convert their preferred investment into a set number of common shares after a predetermined date. The conversion option lets holders potentially participate in the company's equity upside.

How does it work?

How does convertible preferred stock work?

Issuing convertible preferred stock is one of the many ways companies can raise capital to fund their operations and expansion. Companies will choose to sell convertible preferred stock because it enables them to avoid taking on debt while limiting the potential dilution of selling additional common stock.

  • Like regular preferred shares, convertible preferred stock will pay investors a fixed rate of return. They will collect this dividend income as long as they hold the preferred stock (assuming the company has the financial resources to make the payments).

In addition to that fixed return, convertible preferred stock has a conversion option. It enables investors to convert their preferred stock into a set number of common shares (the conversion ratio) at a set price (the conversion price). While the convertible preferred stock investor typically controls the conversion timing, issuing companies sometimes have the option to force the conversion. Investors will often exercise their conversion option when the common stock price exceeds the conversion price. In doing so, they give up their rights as a preferred investor (i.e., they lose the fixed return and preferred claims).

Why invest in it?

Why invest in convertible preferred stock?

Convertible preferred stock gives investors a lower-risk way to invest in a company. They're initially able to earn a fixed return from the dividend payments. Investors earn this return as long as the company has the financial resources to make the payments. Meanwhile, if the company goes bankrupt, preferred investors have a preferential claim on its assets over common shareholders.

In addition, convertible preferred investors can still participate in the company's upside potential through the conversion option. If the common share price rises above the conversion price, the investor can exercise their conversion option and become an investor in its common equity, enabling the investor to participate in its long-term upside. Meanwhile, the investor can continue earning the preferred return if shares never reach the conversion price.

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Example

An example of convertible preferred stock

In 2020, Boston Scientific (BSX 0.16%) sold almost 8.8 million shares of its 5.5% mandatory convertible preferred stock to investors for $100 per share. In a concurrent offering, it sold more than 25.5 million common shares at a price of $34.25 per share. The convertible preferred shares had a mandatory conversion date of June 1, 2023. They would convert into between 2.3834 and 2.9197 shares of the company's common stock based on the volume-weighed average price (VWAP) over the 20 trading days leading up to that conversion data.

Investors in the convertible preferred shares earned a 5.5% annual dividend on those shares until mid-2023, when Boston Scientific called for their mandatory conversion. Investors received 2.3834 shares of the company's common stock for each convertible preferred share they owned (valued at around $50 per share).

By issuing convertible preferred shares, Boston Scientific raised some additional capital from investors while limiting dilution during the pandemic to strengthen its financial position. Investors in those convertible preferred shares earned a fixed return for roughly two years. In addition, the conversion option enabled them to participate in the company's upside since the value of their original $100 investment increased to about $120 when converted into common shares.

Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.