Two common types of attractive investments are warrants and convertible securities. A stock warrant gives investors the right to purchase the underlying security for a particular price. Convertible securities give investors the ability to convert the security into the company’s common stock. Warrants and convertibles possess many variables. Investors deciding whether to invest in warrants or convertibles should understand the difference in features, advantages and disadvantages of both types of securities before making an investment decision.
Understanding Warrants
Investors who purchase warrants inherit the right to purchase the underlying stock or bond at a predetermined price and time. Investors are not obligated to purchase the underlying asset. Unlike convertible securities, investors who trade warrants must pay additional money to obtain the company’s common stock. The time horizon of warrants varies, but many warrants are held for several years. The value of a warrant is made up of two components – time and intrinsic value. The longer time left until expiration, the greater the value of the warrant. Intrinsic value relates to when the market share of the underlying asset is greater than the exercise price.
Pros and Cons of Warrants
A primary advantage of investing in warrants is that investors can potentially earn large returns with only a small amount of money used to purchase the warrant contract. Warrants offer investors diversity through a variety of underlying assets included in warrant contracts. Warrants are liquid assets, which is beneficial if the investor chooses to sell the contract instead of exercising the warrant. A disadvantage of investing in warrants is that you do not enjoy the benefits of stock ownership until you purchase the underlying asset. A warrant is a risky investment, and becomes worthless if the market value of the asset declines lower than the exercise price.
Understanding Convertible Securities
A company without access to bank financing and other traditional financing options may issue convertibles in an effort to raise quick capital. Convertible securities are longer-term investments than warrants, and are usually issued as bonds or preferred stocks that investors can convert to a predetermined number of shares of the company’s common stock. The number of shares given to investors is determined by the conversion ratio. For example, a conversion of 50 to 1 means that investors can convert one bond with a $1,000 face value to 50 shares of common stock.
Pros and Cons of Convertibles
The combination of bond and stock attributes makes convertible securities beneficial for investors. An advantage of investing in convertible securities is if the company’s stock price is undervalued, you can earn a significant rate of return. Investors benefit from convertible bonds because the bond pays a fixed rate of interest until it is converted. This is especially beneficial if the company does not pay a dividend. A disadvantage of investing in convertible securities for some investors is the need to understand the bond and equity markets. Convertible bonds are tied to the issuing company’s credit rating and typically pay less interest than regular corporate bonds. A disadvantage of investing in convertible bonds is that companies with poor credit ratings have a greater risk of defaulting.