Convertible Preferred Stock for Beginners

Understanding What Makes Convertible Preferred Stock Different

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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 class has its characteristics, voting rights, dividend rights, and other costs or benefits. There are several situations and scenarios you may run into if you decide to invest in these much less noticed, and discussed, securities. One of the most popular and common variations of preferred stock is known as convertible preferred stock.

Special Conversion Rights for Preferred Stocks

It might seem confusing to new investors, but it is vital to understand that some preferred stocks might have conversion rights. When this happens, people on Wall Street refer to these securities as convertible preferred stocks or convertible preferreds.

It means that the company might convert all of your preferred stock into shares of common stock at some future point—from your choice, through the decisions of the board of directors, or at a predetermined date. Correctly understanding the terms and conditions of that conversion can mean the difference between big profits or horrendous losses.

An Example of Convertible Preferred Stock

Imagine you read through the terms and conditions of a particular security and 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, which works out to a 5% dividend yield. It also has a special conversion privilege, which says that you can convert each share of preferred stock into 50 shares of common 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 an absolute goldmine.

If you wake up and the common stock is $7, you would not want to use the conversion privilege to exchange your 100 shares of preferred stock for 5,000 shares of common stock. Each share of preferred can be exchanged for 50 shares of common, or 100 preferred shares x 50 common shares = 5,000 common shares. 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 on your original investment of preferred stock at $50,000. Also, you wouldn't receive your preferred stock dividend anymore.

Now, imagine that XYZ Bank made an announcement, and the common stock skyrocketed 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 shares of common stock. You could immediately sell your common stock for $150,000 ($30 per share 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. It makes it easy to see why understanding the terms of your convertible preferred shares is so important.