WHAT DID YOU MEAN WHEN YOU WROTE THAT AN INVESTOR MUST BE MORECAREFUL - ProProfs Discuss

# What did you mean when you wrote that an investor must be morecareful when buying a convertible that is selling off the stock?

Asked by Farrar, Last updated: Mar 29, 2024

#### John Smith

John Smith

Consider a person who buys a \$1,000 face value debenture for \$1,000, and thedebenture can be converted into 25 common shares per \$1,000 of face value. at thetime of purchase, the common shares were trading at \$32. assuming no significantmovements in interest rates, the debenture will trade close to par, particularly since thestock is well below the conversion value of \$40.its not until the price of the stock exceeds the original conversion value that thedebenture would sell off the stock. consider what would happen to the debenture ifthe common stock price rose from \$32 to \$50. the debenture would likely rise in priceto approximately \$1,250 per \$1,000 of face value. intuitively this makes sensebecause anyone buying the debenture for \$1,250 can convert into 25 common sharesworth a current market price of \$50 (25 shares x \$50 = \$1,250).you come along and buy the debenture at \$1,250, paying a price well above par.what happens to your debenture price if, the next day, the common share price fallsfrom \$50 to \$45? the debenture would drop in price to approximately \$1,125.your conversion price in this case was \$1,250 / 25 common shares = \$50. when theprice of the stock rises above \$50, you enjoy a profit as the debenture appreciates inprice. when the price of the stock fell below your conversion price, however, thedebenture continued to fall in price as well - because the common stock was still aboveits original conversion price at the time the convertible securities were issued.whereas the person who bought the debenture for \$1,000 wasnt hurt that much bystock prices below \$40, the person who bought the debenture at \$1,250 must be morecareful about the underlying movement of the common share price.the same type of consideration holds true for convertible preferreds.