Understanding What Makes Convertible Preferred Stock Different

In What Is Preferred Stock? and The Many Flavors of Preferred Stock. you learned that preferred stock is a special type of stock that is sometimes sold to investors. Often, preferred stocks feature higher dividends but they are limited in the total profit they can earn or the dividends they can collect, making them fall somewhere between regular common stocks and bonds. Some companies have multiple classes of preferred stock, each of which has its own characteristics, voting rights, dividend rights. etc. Here are some of the situations you may run into if you decide to invest in these much less noticed, and discussed, securities. One of the most popular variations is convertible preferred stock.

Preferred Stocks Sometimes Have Special Conversion Rights

This might seem confusing to new investors. but it is absolutely vital that you understand preferred stocks might have conversion rights. When this happens, people on Wall Street refer to these securities as convertible preferred stocks, or convertible preferreds. That means that, at some point in the future, either at your option, at the option of the Board of Directors. or at a predetermined date, the company might convert all of your preferred stock into common stock. Understanding the terms and conditions of that conversion right can mean the difference between big profits or horrendous losses.

An Example of Convertible Preferred Stock

Imagine you bought 100 shares of convertible preferred stock in XYZ bank. The preferred stock cost you $500 per share so your total investment is $50,000. This particular class of preferred stock pays $25 per share each year in dividends for a 5 % dividend yield. It also has a special conversion privilege, which says that you can convert each share of preferred stock

Think about that for a moment. Your preferred stock of $500 per share is paying you $ 25 per year in dividends. or a 5% yield. But you also get a lottery ticket that allows you to trade in your preferred stock and exchange it for 50 shares of common stock. That means your cost of converting to common is $10 per share ($500 preferred stock divided by 50 shares of common stock = $10 cost per share in the event of conversion).

If the common stock is less than $10, your convertible preferred rights aren’t worth much. If the common stock is $10 or more, your conversion rights can be a goldmine. An illustration might help.

If you wake up and the common stock is $7, you wouldn’t want to use your conversion privilege because you would exchange your 100 shares of preferred stock for 5,000 shares of common stock (since each share of preferred can be exchanged for 50 shares of common, or 100 preferred x 50 common = 5,000 common). That would leave you with 5,000 shares of common stock at $7 per share, or $35,000. That is a loss of $15,000, plus you wouldn’t receive your preferred stock dividend, anymore!

Imagine, instead, the common stock skyrockets to $30 per share. You would take your 100 shares of preferred stock and convert them into 50 shares of common stock each for a total of 5,000 share of common stock. You could immediately sell your common stock for $150,000 because $ 30 per share market price x 5,000 shares = $150,000. Your cost was only $50,000 when you bought the convertible preferred, so you tripled your money and you collected dividends up until the time you exercised the conversion rights.