Convertible securities provide investors with the benefits of both debt and equity investing. Convertible securities can be either convertible bonds or convertible preferred stock. Either type of convertible security can be converted to the issuing company's common stock at the discretion of the convertible owner. Each convertible security has a conversion price or ratio that determines at what value the convertible security can be exchanged for shares of common stock.
Fixed Rate of Income
As a debt security or preferred stock share, a convertible security will pay a set interest or dividend payment to the investor. This can be an advantage, especially if the issuing corporation does not pay much of a dividend on its common stock. The investor who buys the convertible security will earn a regular income from the investment while waiting for the value of the company's stock to increase.
Participate in Common Share Increase
Since convertible securities can be converted to common stock, the value of the convertible will increase along with any increase in the value of the common stock. The convertible security will reflect the value of the common stock when the common rises toward and above the conversion price of the convertible. The convertible security owner has the option of selling the convertible to realize the gain or tendering the bond to the issuer for conversion and receiving the shares of common stock.
Lower Rate of Interest for Issuer
Corporations also have reasons for issuing convertible bonds. Companies can issue convertible securities at a lower rate of interest than they would pay on regular bonds or preferred shares. Investors are willing to accept a lower rate in exchange for the conversion feature. The interest paid to convertible bond holders is also tax deductible as a business expense. This helps reduce the cost to the corporation of raising capital.
Opportunities for Arbitrage
Traders can use the pricing differences between a company's convertible securities and common stock as opportunities for price arbitrage. If there is a pricing discrepancy, a trader can lock in an automatic profit by purchasing one security and selling the other short. This can happen when the common shares exceed the conversion price. The trader will buy the bond and simultaneously sell the shares short. The bond is converted to shares at a lower-than-market price, and the trader uses those shares to cover the short sale and pockets the difference between where the bond market values the convertible and the stock market values the common stock.