Convertibles are hybrid securities; in other words, they combine the characteristics of two different types of investment instruments. Hybrids are found in two basic forms: convertible bonds and convertible preferred stock. These bonds and preferred stock can be exchanged for (or, converted to) a specified number of the issuing company's common stock shares at the option of the convertible holder. There are also other less-common types of combination securities, such as payment in kinds (PIKs) and hybrid convertibles, to name a few. Each of these different types of securities has conversion options or relationships to other types of securities or assets.

Convertible bonds are long-term debt instruments that have many of the same features as regular bonds. They're generally issued with a face (or par) value of $1000 and come with a maturity date (assuming that the conversion is never exercised). Issuers may pay interest on the bonds semiannually or annually. Some issues also have call provisions, which the issuers often use to force the bondholders to convert the bonds. This is advantageous for the issuer because once the conversion is made the issuing firm no longer has to repay the debt.

By issuing convertible bonds, companies can tap into additional credit markets more easily. Due to the conversion feature, companies can issue convertible bonds with lower coupon rates (the bond's stated rate of payable interest) than they could on regular bonds. Additionally, convertible bonds are usually subordinated to the issuing company's other outstanding debt issues. Investors are willing to accept lower rates and lower-quality debt in return for the possible appreciation of the issuing company's stock. In other words, investors are willing to sacrifice some current income for the possibility of future capital gains. Convertibles generally appeal to investors who may be somewhat nervous about investing directly in a company's common stock. This is because convertibles typically fall less in down markets than do stocks (however, they also rise less than stocks when markets are going up).

To understand convertible securities, let's use this example: a corporation needing to raise capital decides that because the market price of its common stock is already low, it doesn't want to issue more shares. To raise the desired amount of cash, the company would have to issue many more shares of stock, which would dilute earnings further for their existing shareholders. Furthermore, a regular debt issue (normal bonds) would also be too costly because the company would have to offer a coupon rate competitive with existing comparable corporate debt issues.

Instead, the company decides to use a $1,000 par value convertible bond issue that, because of the conversion feature, investors will accept at a lower coupon rate. In order to do this, the company must evaluate the current market price of its common stock to determine the number of shares that each bondholder will receive through a conversion. For instance, if the company's stock is currently trading at $14 per share, it may decide on a conversion price of $20 to make the bonds more appealing to investors. The conversion ratio – the number of common shares received for each bond – would therefore be 50 ($1,000 face value of the bond divided by $20 conversion price = 50 shares per bond). The convertible can be valued relative to the conversion value of the stock or as a straight bond. In reality, investors use both of these factors when evaluating the worth of a convertible security.

Convertible preferred stock is similar to convertible bonds. The holder of the convertible has the option to convert each share of preferred stock into a fixed number of shares of the issuing company's common stock. However, the conversion ratio for convertible preferred stock is typically small; it may even be as low as one for one. Unlike the interest payments of convertible bonds, dividends are paid only if the company's board of directors declares them. Although the number of convertible preferred stock issues has increased over the years, they're generally not as popular as convertible bonds.

Hybrid convertibles are debentures of one company that are convertible into the common stock of another company. Companies that have accumulated a substantial number of shares of a different organization can issue hybrid convertibles as a way of raising capital. Investors purchasing such issues should not only perform their due diligence to ensure that the debt of the issuing company is attractive, but that the equity and potential gains of the convertible company are appealing, as well.

Another type of combination security is the payment in kind, or PIK. In some respects, PIKs resemble zero-coupon securities in that interest (or dividends in the case of preferred stock PIKs) isn't paid out in cash to the investor in the early years. Instead, it's paid in the form of additional securities of the underlying issue. For bonds, interest paid is in the form of additional bonds; for preferred stock, dividends would be in the form of more preferred shares.

PIKs tend to carry higher coupon rates to entice investors to buy. However, investors should examine the issuing company's financial status very carefully in order to determine the solidity of the organization and whether it's likely to still be solvent in future years. It must be remembered that with higher returns always come higher risks.

SIRENs, or step-up income redeemable equity notes, are convertible bonds that come with two coupons. The first coupon carries a below-market rate of interest. After a few years, the coupon increases to a higher rate that remains in effect until the bond's maturity. SIRENs have a convertible provision that allows holders to convert the notes into the issuer's common stock at a price determined by the issuer. This is known as the conversion price. As is characteristic with other convertibles, if the price of the common stock goes up, the holders stand make a profit. Conversely, if the stock goes down in value, holders of SIRENs are protected with a floor price on their notes, but they will nevertheless earn less than they would on a similar conventional bond.

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