A convertible security is any type of security that has the potential to be exchanged for other forms of security offered by the same issuing party. Generally, there are certain conditions that must be met before the conversion can take place. Depending on the structure of the terms and conditions associated with the convertible security, both the issuer and the investor may have the ability to initiate the conversion process.
One of the more common examples of a convertible security situation has to do with bonds issued by a particular company. The bond issue may be structured in such a way that it is possible to convert the bond into shares of common stock at some point during the life of the bond, or at the point of maturation. Within this example of debenture, the price that will apply to each share of stock issued as part of the conversion from the bond will be set within the terms and conditions that applied at the time the bond was purchased. The investor receives shares of stock instead of interest returns on the purchase, and the bond is considered to be retired.
Another fairly frequent application of a convertible security has to do with converting a bond into equity of some type. Both businesses and municipalities that issue bonds for short term financing utilize this model fairly often. An investor who chooses to accept the equity in exchange for his or her interest in the bond issue often will make a higher return on the investment over the long term.
A less common occurrence with a convertible security has to do with the conversion of preferred stock into common stock. Within this scenario, the investor holding shares of convertible preferred stock may be in a position to exchange those shares for common shares. In some instances, the issuer and not the investor must initiate this conversion process. However, there is usually some underlying reason for this action that is intended to ultimately protect both the issuer and the investor.