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8.3.6 Convertible Preferred Shares

An in-depth guide to understanding convertible preferred shares, their characteristics, benefits, and how they differ from straight preferred shares.

Overview of Convertible Preferred Shares

Convertible preferred shares exhibit similarities to convertible bonds and debentures. They grant the holder the ability to convert the preferred shares into another class of shares (typically common shares) at a predetermined price within a stipulated timeframe. Additionally, some issuances allow conversion privileges to both the holder and the issuer.

Conversion Terms

The conversion terms are defined at the time of issuance and usually specify the number of common shares into which each preferred share is convertible. The preferred price typically includes a modest premium (approximately 10% to 15%) over the converted value, intended to deter early conversions that counter the purpose of the convertible offering. Typically, conversion privileges expire within five to twelve years from the date of issue.

Example: GHI Inc.

GHI Inc.’s 4.70% Non-Cumulative Preferred Shares, Series J can be converted by the holder upon a minimum of 65 days’ notice beginning July 31, 2022, and on the last day of January, April, July, and October every year. The conversion rate is determined via a formula that considers the conversion date, declared and unpaid dividends, and the weighted average trading price of the common shares on the Toronto Stock Exchange (TSX) over a specific period. These shares also grant conversion privileges to the company starting April 30, 2020, under various terms.

Characteristics of Convertible Preferred Shares

Convertible preferred shares often trade at a premium over their expected selling price based on conversion terms, represented either in dollar amounts or percentages. This premium is typically balanced by their often higher yield compared to the underlying common shares, which compensates the investor over time for the premium required to purchase them.

Example: JKL Inc.

JKL Inc. common shares trade at $20 per share with an annual dividend of $0.40 (2%). JKL Inc. 3.33% Non-Cumulative Preferred Shares, with a par value of $60, are convertible into three common shares and currently trade at $62.50 per share. These convertible preferred shares pay an annual dividend of $2.

Even though the preferred shares trade at a premium (three common shares are worth $60 while the convertibles trade at $62.50), the convertibles pay a higher yield than common shares. Over time, the higher yield compensates for the premium.

Share Type Trade Price Annual Dividend Dividend Yield
JKL Inc. Common Shares $20 $0.40 2%
JKL Inc. Preferred Shares $62.50 $2 3.36%

Practical Considerations

Convertible preferred shares are often issued in markets where straight preferred shares are challenging to sell or where a high level of dividend coverage is absent. The conversion feature generally results in a lower dividend compared to a comparable straight preferred share.

Characteristics from a Purchaser’s Perspective

The following list summarizes the key characteristics of convertible preferreds from the holder’s standpoint:

  • They act as a two-way security, offering more secure positioning than common shareholders and potential capital gains if the market price of common shares rises sufficiently.
  • They typically offer a higher yield than the underlying common shares but typically lower than comparable straight preferreds.
  • Conversion to common shares can be done without paying a commission.
  • Upon conversion, they might convert into less (or more) than a standard trading unit of common shares, potentially making them harder to sell.
  • When the conversion period expires without conversion, they revert to straight preferreds.

Key Takeaways

  1. Conversion Method: Convertible preferred shares can be swapped for common shares at a predetermined price within a set time frame, with both companies and holders potentially holding conversion rights.
  2. Premium & Yield: These shares frequently trade at a premium but typically offer higher yields to offset these premiums over time.
  3. Individual Examples: Important insight can be drawn from specific examples, such as JKL Inc., where the convertible shares provide a higher yield than the underlying shares.
  4. Market Circumstances: Convertible preferreds are usually issued in less favorable market conditions or within companies with limited dividend coverage.
  5. Purchaser’s Benefits: Convertible preferred shares provide an attractive security structure with the flexibility to convert and engage in capital gains without commissions.
  6. Reversion: Should conversion be neglected before expiration, these often revert to straight preferred stock status.

FAQs About Convertible Preferred Shares

Q1: What is the main advantage of holding convertible preferred shares?

A1: The primary benefit is the potential to convert preferred shares into common shares, allowing the investor to participate in capital gains if the company’s stock price rises.

Q2: Why do convertible preferred shares often come with a premium?

A2: The premium deters early conversion by offering a higher yield compared to common shares, thereby compensating the investor over time for the initial premium.

Q3: Can both the holder and the issuer exercise conversion privileges?

A3: Yes, in some cases, issuance allows conversion privileges for both parties under specific terms set upon issuance.

Q4: What happens when the conversion period expires without conversion?

A4: The shares typically revert back to the status of straight preferred shares, devoid of any conversion privileges.

Glossary

  • Convertible Preferred Shares: A type of preferred stock that can be converted into a specified number of common shares.
  • Dividend Yield: A company’s annual dividend payment divided by its share price, expressed as a percentage.
  • Straight Preferred Shares: Preferred shares that do not include any conversion rights.
  • Premium: The extra cost paid above the converted value of the shares.
  • TSX (Toronto Stock Exchange): The primary stock exchange in Canada.
  • Dividend Coverage: Indicates how well a firm’s earnings can pay out dividends to shareholders.
  • Par Value: The face value of a bond or preferred stock.
  • Capital Gain: Profit from the sale of securities or assets.

CSC® Exams Practice Questions

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## What are convertible preferred shares primarily similar to? - [ ] Common shares - [x] Convertible bonds and debentures - [ ] Treasury bills - [ ] Growth stocks > **Explanation:** Convertible preferred shares enable the holder to convert the preferreds into some other class of shares at a predetermined price, similar to the convertibility feature of bonds and debentures. ## What is the purpose of the premium set on convertible preferred shares when issued? - [ ] To encourage early conversion - [ ] To decrease the overall yield - [ ] To balance between common and preferred share prices - [x] To discourage early conversion > **Explanation:** The premium is usually set at 10% to 15% to discourage early conversion, ensuring the convertible offering achieves its purpose. ## After how many years do most conversion privileges of preferred shares typically expire? - [ ] 1 to 3 years - [ ] 3 to 5 years - [ ] 5 to 12 years - [x] 5 to 12 years > **Explanation:** Most conversion privileges expire between five to twelve years from the date of issue of the convertible preferred shares. ## When can GHI Inc.’s Series J preferred shares be converted by the holder? - [ ] At any time without notice - [x] On the last day of January, April, July, and October each year with a minimum of 65 days' notice - [ ] Only during the company’s annual general meeting - [ ] Every quarter without notice > **Explanation:** Holders of GHI Inc.’s Series J preferred shares may convert them on specific dates with a minimum of 65 days' notice, as outlined. ## How can the premium on convertible preferred shares be expressed? - [x] As both a dollar amount and as a percentage - [ ] Only as a dollar amount - [ ] Only as a percentage - [ ] As a ratio between the preferred and common shares > **Explanation:** The premium on convertible preferred shares can be expressed both as a dollar amount or as a percentage. Expressing it as a percentage makes comparisons easier. ## What usually offsets the premium on convertible preferred shares? - [ ] Lower risk - [ ] Higher liquidity - [ ] Equally matched dividend yields - [x] Higher yield compared to the underlying common shares > **Explanation:** Higher yield that the preferreds offer compared to the underlying common shares typically offsets the premium on convertible preferred shares. ## How does the dividend on convertible preferred shares typically compare to that of a comparable straight preferred? - [ ] Higher - [ ] Same - [x] Lower - [ ] No dividend > **Explanation:** Due to the added benefit of a conversion feature, convertible preferreds often have a lower dividend compared to a comparable straight preferred. ## Why are convertible preferred shares attractive to purchasers? - [ ] They provide a higher yield than any other investment - [ ] They do not offer capital gains potential - [ ] They have an indefinite conversion period - [x] They can provide a two-way security, offering both potential capital gain and higher yields > **Explanation:** Convertible preferreds can provide a two-way security by offering a higher yield than common shares and potential capital gains if the market price of the common shares rises. ## What can happen to convertible preferred shares if the conversion period expires without conversion taking place? - [ ] They become common shares - [ ] They provide additional dividend - [ ] They lose all value - [x] They revert to straight preferreds > **Explanation:** If the conversion period expires and no conversion has taken place, convertible preferred shares usually revert to straight preferreds. ## What does 'dividend coverage' refer to? - [x] The amount of money available to pay dividends to preferred shareholders from after-tax profits - [ ] The percentage of dividends paid out annually compared to net income - [ ] The maximum dividend rate a company can offer to shareholders - [ ] The level of security offered by dividends against market fluctuations > **Explanation:** Dividend coverage refers to the amount of money a firm has available from after-tax profits to pay dividends to preferred shareholders.

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Sunday, July 21, 2024