A residual security is any type of any type of security that might be converted into common stock of the issuing company at some point in the future by the security's holder. The two most common types of these securities are convertible bonds and convertible preferred stock. With both of those instruments, the holder generally has the opportunity to convert them into common stock if the underlying stock price exceeds a certain predetermined limit. One drawback of a residual security for the issuer is that it has the potential to dilute earnings per share measurements by increasing the number of outstanding shares.
There are times when investors have the opportunity to partake of a kind of hybrid investment that combines characteristics of both fixed income and equity. This can be useful for investors who aren't ready to make the commitment to buy equity unless the price of the stock goes up. Companies issue these securities as a way to raise money. Such a security is known as a residual security, which contains benefits and drawbacks for investors and companies alike.
As an example of how a residual security works, an investor might buy a convertible bond that returns regular interest payments just like a normal bond would. The difference is that the convertible bond has a strike price, which is the price of the underlying stock at which the conversion process begins. Once this price is reached, the investor has the opportunity to trade the bond in for a predetermined amount of stock shares.
Convertible preferred stock, another type of residual security, works in much the same fashion as convertible bonds. In this case, however, the fixed income element of the security comes not from interest payments but instead from dividend payments. With both of these instruments, as well as other, rarer forms of residual securities, the danger for investors comes if the underlying stock price never reaches the strike price and the conversion doesn't occur. If that's the case, these securities will generally underperform compared to other fixed income instruments.
Any company that issues a residual security may use the money raised by the issuance to fund some new business initiative. If the securities are converted into common stock, however, the results can be damaging to the company's earnings per share, a key metric that is studied by investors. When investors convert bonds and preferred stock into common stock, it raises the number of outstanding shares of stock. Since earnings per share is calculated by dividing a company's earnings by its outstanding shares, a higher number of outstanding shares means a lower earnings per share.