Convertible Security

A convertible security is a bond or a share of preferred stock that gives its holder the right to exchange it for a fixed number of common shares of the same company. It starts out behaving like a fixed-income instrument, paying interest (if it's a bond) or a dividend (if it's preferred stock), but it carries a built-in option to switch into stock.

The exchange rate is set when the security is issued and is called the conversion ratio — it tells you how many common shares you get for each convertible unit you hold. From that ratio you can back out a "conversion price," the effective price per share you'd be paying if you converted. As the company's stock price rises above that conversion price, the convertible tends to trade more like the stock itself; when the stock is well below the conversion price, the convertible trades more like an ordinary bond, valued mainly on its interest payments and credit quality.

The nuance that trips people up is that conversion is usually one-way and optional for the holder, not automatic. Holding the convertible doesn't make you a shareholder — you still own a bond or preferred share with its own price, credit risk, and (for bonds) maturity date — until and unless you actually convert. Some convertibles also let the issuer force conversion or call the security back under specific conditions, which caps how much upside a holder can capture.

Because a convertible blends debt-like and equity-like behavior, its price sensitivity to the stock isn't constant. Traders watch a measure of that sensitivity, informally called the "delta" of the convertible, to gauge how much it will move for a given move in the underlying shares.