A financial security that gives its holder (an investor) the right to convert it into another security issued (or to be issued) by the same firm (issuer). The most popular types of convertible securities are convertible bonds or convertible preferred stocks that regularly pay interest (coupons) and can be converted into shares of the issuer’s common stock. The conversion ratio is determined at the time of issuance, while convertibility is typically subject to specific conditions such as a lookout period.

Convertible instruments have the characteristics of both stocks and fixed-income securities. Similar to stocks, convertibles provide upside appreciation potential in rising equity markets and have lower correlation with to interest rates. And similar to bonds, convertibles provide a stable source of income and potentially less exposure to equity downside.

The hybrid nature of a convertible security confers on it a unique risk/ reward profile that appeals to investors who seek to secure equity participation while desiring to forgo maximum upside potential against mitigation of a substantial exposure to equity downside.