Convertible Debentures and Bonds

Convertible debentures are often viewed by investors as a superior investment choice compared to fixed deposits. Key factors such as liquidity, potential for higher yields, and opportunities for capital appreciation are typically the main attractions for investors. 

Let's delve deeper into this debt instrument and explore its various aspects as an investment option.

What is a Convertible Debenture?

A Convertible Debenture is a form of long-term debt instrument typically issued by a company, offering the option to convert into equity shares at a later stage.

 

Typically, shareholders hold the decision-making power regarding the conversion of debentures into equity shares, treating debenture holders as creditors or lenders. However, in certain cases, issuers may retain conversion rights.

 

These debentures are usually unsecured, meaning they lack underlying collateral as security. They are commonly issued by businesses to avail tax benefits, as companies issuing convertible debentures can claim tax deductions on the interest paid to investors.

 

It's important to note that convertible debentures often offer lower interest rates compared to traditional debt instruments. However, they provide the opportunity for bondholders to convert them into stocks at predetermined times, helping mitigate some of the associated risks involved in investing in them.

Types of Convertible Debentures

Convertible debentures come in two main types:

1. Fully Convertible Debentures (FCDs)

Fully Convertible Debentures (FCDs) are debt instruments that can be entirely converted into equity shares at a predetermined conversion ratio. Once converted, FCD holders become shareholders in the issuing company, relinquishing their creditor status.

2. Partly Convertible Debentures (PCDs)

Partly Convertible Debentures (PCDs) retain a portion of their value as debt while offering the option to convert the remaining portion into equity shares. The conversion ratio and terms are specified at the time of issuance, allowing investors to retain some debt-based income while potentially benefiting from equity participation.

 

Below, is the dissection of the characteristics of each category:

 

 

Exploring the Key Features of Convertible Debentures

• Rate of Conversion: The conversion rate determines the number of equity shares obtained upon debenture conversion.

• Cost of Conversion: The conversion price, set at issuance, determines the equity share price at which debentures convert. It considers various factors like market sentiment and expected price movement.

 

• Convertible Value: The post-conversion value equals the number of equity shares multiplied by the current share price.

• Quantum of Conversion: This percentage of debenture holdings converts into equity shares, predetermined at issuance as a percentage of the debenture’s face value.

• Date of Conversion: The specified date for debenture-to-equity conversion, contingent on debenture tenure and terms.

• Interest: Debenture interest varies based on issuer credit rating, payment history, and is typically paid annually or semiannually. Interest ceases upon conversion.

• Premium: The premium reflects the difference between debenture price and current market equity share price, aiding in risk-return assessment.

Advantages of Convertible Debentures:

• Fixed Interest: Offering predictable returns akin to fixed deposits, often with higher interest rates.

• Equity Upside: Allows benefiting from potential equity gains through conversion.

• Option to Convert: Investors can choose conversion based on favorable market conditions or retain the debenture for interest income.

• Lower Risk: Balances fixed income stability with equity potential, mitigating market volatility.

• Preference: Debenture holders have precedence over equity in bankruptcy or liquidation scenarios.

Limitations of Convertible Debentures:

• Lower Interest Rates: Interest rates are typically lower than traditional debt instruments due to equity conversion potential.

• Equity Risk: Shares' volatility affects investment value post-conversion.

• Default Risk: Unlike fixed deposits, debenture investments carry default risk.

• Investor Rights: Debenture holders have secondary rights in asset claims compared to traditional bondholders in liquidation.

In Conclusion:

Convertible debentures offer a hybrid investment option blending debt stability with equity potential. Assessing issuer credibility and market conditions is crucial before investing, ensuring alignment with individual risk-return preferences.

Frequently Asked Questions

1. Why do companies issue convertible debentures?

Companies issue convertible debentures to raise funds for expansion and growth. By offering an equity conversion option, they manage debt while attracting investors.

 

2. What is the difference between convertible and non-convertible debentures?

Convertible debentures allow conversion into equity shares, while non-convertible debentures remain pure debt instruments without equity conversion options.

 

3. How does a convertible debenture work?

Convertible debentures provide fixed interest and offer the choice to convert part or all holdings into equity shares as specified at issuance.

 

4. What happens to convertible debentures when interest rates rise?

Rising interest rates may lower the face value of debentures. Selling before maturity may incur losses, but holding to maturity ensures principal payout or conversion to equity shares.

 

5. Is a debenture an asset or a liability?

Debentures represent debt on a company's books, making them a liability. Companies must pay interest to debenture holders and repay the principal upon maturity.