A convertible security is a bond, preferred stock, or a similar financial instrument that can be converted into the common stock of the issuing entity. When an investor elects to convert a security into common stock, this results in the elimination of the fixed stream of payments associated with the original investment and replaces it with stock that does not have such a related payment stream. Consequently, the only realistic inducement for an investor to trigger the conversion is when the market price of the common stock is so high that an immediate profit can be realized by selling the shares on the open market.
Investors want the option to convert into common stock, so they are usually willing to accept a lower rate of return on the interest payments being made to them on the original convertible security. A large price discount means that investors believe there is an opportunity to earn a substantial return on the underlying conversion feature.
The conversion feature is usually only made available to investors at a higher price than the market price of the issuer’s common stock when the convertible security was originally issued. The value of the underlying call option increases as the market price of the common stock approaches the conversion price. Conversely, the value of the call option declines as the market price of the common stock drops below the conversion price.
When investors convert their securities into the common stock of the issuer, this dilutes the ownership interests of existing stockholders. This dilution effect is included in the diluted earnings per share figure, which is reported in the financial statements of publicly held entities.