A security that, at the option of the holder, may be exchanged for another asset, generally a fixed number of shares of common stock. Convertible issues frequently are fixed-income securities such as debentures and preferred stock. Their prices are influenced by changes in interest rates and the values of the assets into which they may be exchanged. Convertible securities vary in price to a greater degree than straight debt, but to a lesser degree than the underlying asset. Also called convertible. See also bond conversion, conversion premium, conversion price, conversion ratio, conversion value, mandatory convertible security.
Case Study In 2006, giant real estate investment trust Equity Office Properties Trust issued $1.5 billion in debt convertible into the firm's common stock. The issue was unusual not only because of its large amount of borrowing, but also because of the purpose of the issue—raising cash that would be used to repurchase the firm's own common stock. The company was issuing a security convertible into common stock in order to raise funds to reduce the number of shares of common stock. The issue carried a 4% coupon and was convertible into common stock at a price of $43 per share. The proceeds of the issue were used to repurchase 17.2 million shares at the current market price of $36.21. Essentially the company was able to acquire stock for debt that would eventually be converted into stock at a price more advantageous to the company. The downside was the firm incurred an additional $1.5 billion of debt and was obligated to pay $60 million more in annual interest expense. A private equity company acquired the firm for over $50 per share the following year.
A bond, preferred stock, or warrant that is
convertible to the issuer’s common stock or some other security under certain
circumstances. The conversion may come with a payment of cash or usable
Case Study Convertible securities sometimes sport unusual features that can make these investments difficult to evaluate. In July 2001 Norvellus Systems, a manufacturer of semiconductor production equipment, issued unrated zero-coupon bonds convertible into shares of the firm's common stock at a price of $76.36 per share, a 50%premium to the market price. Zero-coupon debt securities are popular with many borrowers and investors, so the lack of a coupon on the issue was not especially unusual. The unique feature was the issue price of the bonds, which were sold at face value rather than a discount to face value. Virtually all zero-coupon bonds are issued at a discount to par value, thus attracting buyers who are assured of earning a positive return in the event the securities are held to maturity. To attract investors to this unique bond Norvellus agreed to allow bondholders to redeem their securities at par value at the end of one year. In other words, buyers of the securities were guaranteed they would be able to recoup their original investment at the end of a year if they were unhappy with the firm's stock price performance. During the first year Norvellus invested proceeds of the bond issue in U.S. government securities. The government securities collateralized its bonds and allowed the firm to earn interest income at the same time it was not paying interest to bondholders who had purchased the firm's debt. Holders of the convertibles who decided not to redeem the bonds at the end of the first year held a debt security that could be converted into common stock but paid no interest.