Convertibles and preferreds

"Neither fish nor fowl" is a commonly cited folk saying referring to something that's difficult to define or classify. But amid the typically well-defined boundaries of investment performance, "fish and fowl" may be a more apt description for some securities. While there may be many kinds of hybrids in the investment universe, convertible bonds and preferred stock occupy important positions. Each has investment performance characteristics that could combine some degree of exposure to both equity and debt of a particular issuer.

What is "preferred" about preferred stock?

Preferred shares are so called because they give their owners a priority claim whenever a company pays dividends or distributes assets to shareholders. They offer no preference, however, in corporate governance, and preferred shareholders frequently have no vote in company elections.

The exact terms of preferred shareholders' economic preference may vary from company to company. In some cases, the preference states simply that cash available for distributions during the year must be used to meet promised payments to preferred shareholders before any common dividends can be paid. In other cases, the preference is applied cumulatively so that any missed payments to preferred shareholders must be made up before common shareholders are allowed to receive anything.

One consequence of the preference system is that preferred shares may provide equity investors with more stable cash flow potential relative to common stock, behaving in this dimension more like an investment in bonds than stock. But unlike bonds, preferred shares carry no general commitment to repay principal. And the market value of preferred shares tends to behave more like common stock, varying in response to the business performance and earnings potential of the issuer.

In addition to these general characteristics, there are many individual considerations when evaluating a preferred stock investment.

  • Many preferred share issues use a percentage in the title. This percentage typically refers to the size of the promised dividend expressed as a portion of the share's issuance price. A preferred share's dividend yield is typically its promised (or most recently declared) dividend as a portion of current market value.
  • Preferred stock dividends are generally not considered automatic entitlements but instead are typically declared individually by the board of directors. Any unpaid preferred dividends would generally rank below obligations to creditors in the event of bankruptcy or liquidation.
  • Companies may issue multiple series of preferred shares, each of which has different economic rights. Frequent distinctions include the relative size of each series' dividend and the order of preference for payments. Each series must be evaluated individually to understand the value of its dividend promises and the strength of its particular preference.
  • Holders of preferred shares may recover some or all of the issuance value of their shares in the event of the company's liquidation. Their claims on residual assets would typically rank ahead of common stockholders but behind bondholders and secured creditors.
  • Preferred shares may come with mandatory or optional features that allow the company to buy shares back at a predetermined price or to convert preferred shares to common shares. Parameters for these call or conversion options should be spelled out in a prospectus or other formal offering document.
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Convertibility may give bonds some equity potential

A convertible bond can be seen as part bond and part stock option. Like a conventional fixed income security, a convertible generally pays interest periodically and can be redeemed at some predetermined time for cash. But like a stock option, a convertible may be exchanged for a predetermined number of equity shares of the issuer, using its face value as the cash input for the exchange.

Convertible bonds typically offer lower yields than conventional bonds of similar duration from the same issuer, even though the convertibles may offer higher return potential over time due to their exchange features. Convertibles also have greater price volatility. The volatility and return potential are driven by the value of the bond’s interest and redemption payments and the value of the equity option.

The bond portion's value in a convertible tends to vary as conventional bonds would—with changes in market interest rates and perceived credit risk. The equity option's value, on the other hand, may respond like shares of stock to changes in the company's business performance, increasing or decreasing in value as profit prospects change.

As with preferred shares, convertible bonds may have issue-specific factors that can have a significant impact on their investment value.

  • The equity option can effectively be a put or a call. Some convertibles give the investor the right to choose when or whether to exchange the bond for shares. Some convertibles allow conversion only at predetermined times. Some allow the issuer to require conversion under specified circumstances or to restrict investors' ability to request conversion.
  • The bond itself may be callable, which could effectively restrict or eliminate conversion options or price appreciation potential.
  • Certain convertible bonds (those designated as subordinated debentures) may have a lower rank in bankruptcy than other debt securities.

When considering convertible bonds and preferred stock, keep in mind that every issue of these securities is an individually customized hybrid with its own unique risk and reward potential. A careful study of specific terms is needed to determine whether the security's investment profile will fit any particular portfolio objective.

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© 2017 by DST Systems, Inc. Reprinted with permission from DST Systems, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Preferred securities are subject to interest rate risk. (As interest rates rise, preferred securities prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Preferred securities also have credit and default risks for both issuers and counterparties, liquidity risk, and, if callable, call risk. Dividend or interest payments on preferred securities may be variable, be suspended or deferred by the issuer at any time, and missed or deferred payments may not be paid at a future date. If payments are suspended or deferred by the issuer, the deferred income may still be taxable. See your tax advisor for more details. Most preferred securities have call features that allow the issuer to redeem the securities at its discretion on specified dates, as well as upon the occurrence of certain events. Other early redemption provisions may exist, which could affect yield. Certain preferred securities are convertible into common stock of the issuer; therefore, their market prices can be sensitive to changes in the value of the issuer's common stock. Some preferred securities are perpetual, meaning they have no stated maturity date. In the case of preferred securities with a stated maturity date, the issuer may, under certain circumstances, extend this date at its discretion. Extension of maturity date will delay final repayment on the securities. Before investing, please read the prospectus, which may be located on the SEC's EDGAR system, to understand the terms, conditions, and specific features of the security.