Convertible instruments are debt or equity instruments that either require or permit the investor to convert the instrument into equity securities of the issuer. Some convertible instruments are convertible only upon the occurrence of a specified contingent event (e.g., upon an IPO).

An optionally convertible instrument is a debt or equity instrument that the investor has the option to (1) hold to maturity and redeem for par value, or (2) exercise the conversion option and receive shares. Convertible instruments are usually settled in the issuer’s common shares. If the conversion option is “in the money,” the shares are worth more than the par value of the instrument. Investors typically exercise the conversion option when it is in the money at (or close to) the instrument’s maturity date. Exercising the conversion option at an earlier date causes the investor to forfeit the remaining time value of the conversion option. Rather than early exercising a conversion option, investors looking to exit a convertible instrument often sell it to another investor that will pay for both the intrinsic and time value of the conversion option. If the issuer’s common stock price does not reach a level where the conversion option is in the money, the investor may decide not to exercise its option, the instrument will mature, and the investor will receive the par or stated value.

One of the key benefits to convertible instrument issuers is the relatively low cash coupon or dividend when compared to a similar nonconvertible instrument. The reduced interest or dividend rate is a result of the value of the conversion option. In other words, the issuer of a convertible instrument “buys down” the interest rate or dividend by selling the investor the conversion option embedded in the debt or equity host instrument.

See FG 7 for information on the accounting for convertible preferred stock.