Most investors consider convertible debentures to be a more lucrative investment option than fixed deposits. Generally, aspects of these debentures like – liquidity, higher yield and scope of capital appreciation, draws the most attention from the populace.
Following is a close look at this debt instrument, and everything it encompasses as an investment option.
In this article
What is a Convertible Debenture?
Convertible debentures meaning can be described as a long-term debt instrument. Typically, a convertible debenture is issued by a company and can be converted into equity shares eventually. Notably, the decision to convert debentures into equity shares lay with shareholders, and they are treated as the creditor or lender. Regardless, in some cases, issuers may possess the conversion rights.
These are unsecured bonds or loans, which means there is often no underlying collateral service as security. Generally, businesses issue such long-term debt instruments to avail tax-saving benefits. For instance, companies that issue convertible debentures are entitled to claim tax deductions on the amount of interest paid to investors.
It must be noted that convertible debentures yield a lower interest when compared to pure debt instruments. Such debentures can be exchanged for stocks at specific times; in turn, enabling bondholders to offset at least some risks involved with putting money in them.
Types of Convertible Debentures
These debentures are of two kinds, namely –
- Fully convertible debentures
- Partly convertible debentures
Details of these two types of convertible debentures are elucidated in this table below –
|Parameters||Fully Convertible Debentures||Partly Convertible Debentures|
|Definition||The value of these convertible debentures can be changed into the company’s equity shares.||Only some portion of the debentures would qualify for conversion into the company’s equity shares.|
|Capital base||Their conversion leads to higher equity capital.||Their conversion leads to lower equity capital.|
|Flexibility in terms of financing||They have a highly favourable debt-equity ratio.||They have a favourable debt-equity ratio.|
|Classification for calculation||They are classified as equity.||The convertible portion is classified as equity, whereas, the non-convertible part is classified as debt.|
|Ratio of conversion||The ratio is determined at the time of issuance of securities.||The ratio is determined when the securities are issued.|
|Suitability||Fully convertible debentures are suitable for companies which do not have an established track record.||Partly convertible debentures are suitable for those companies that have an established track record.|
|Popularity||They are highly popular among investors.||They are not very popular among investors.|
Features of Convertible Debentures
In a broader sense, a convertible debenture is a kind of hybrid security and hence manifests characteristics of both – debt and equity.
These are other prominent features of convertible debentures.
- Conversion price – It is essentially the price at which an ordinary share is issued and subsequently allotted to debenture holders. The conversion price depends on factors like – current book value, market price, anticipated appraisal in equity share value, etc. Higher conversion prices lead to lower addition to the capital base.
- Conversion rate – The ratio indicates the number of equity shares received against a convertible bond.
- Quantum of conversion – It is the number of debentures to be converted and is expressed in terms of a percentage of its face value.
- Coupon payment – Its value depends on an issuer’s credit quality and prevailing interest rates. The break-even analysis proves useful in comparing coupon payouts against dividend yields of common shares.
- Convertible value – It is the value of these debentures that is mainly based on an investor’s right to receive equity shares. It is the conversion ratio multiplied with the market price of each equity share.
- Timing of conversion – It usually ranges between a year (from the date of allotment) and 5 years.
- Market Price – This price is decided as per the investment and conversion value of this debt instrument. Essentially, the market price is given as the value the market attaches to a convertible debenture.
- Premium – It is merely the sum of money by which the market price of a convertible debenture is more than its overall conversion value.
Benefits of Convertible Debentures
From a business’ point of view, these debentures are considered to be among the quickest and most feasible ways of raising funds. Companies issue debentures, and with the funds raised, they accelerate the growth and profitability of their venture.
The most popular benefits of convertible debentures for investors are as follows –
- Investors receive a fixed-rate and also have the option to partake in stock price appraisal.
- In case an issuer’s stock price declines, investors are entitled to hold onto the bonds until maturity.
- Convertible debenture holders are paid before other stockholders in the event of liquidation of the company.
- Being a hybrid investment instrument, investors are entitled to fixed interest payouts and also have the option of converting their loan to equity when the company is performing well or when its stock prices are rising.
To gain a better picture of convertible debentures example, intending investors should make it a point to weigh in the debt-instruments limitations as well.
Limitation of Convertible Debentures
The most noteworthy drawbacks of convertible debentures as investment options include –
- When compared to traditional bonds, convertible debenture holders accrue a lower interest rate.
- Debenture holders may be subject to the risk of company default. In such a situation, the company will be unable to repay even the principal amount to investors.
- In case the stock prices decline after the conversion of debentures into equity, investors could lose their invested money.
Investors should factor these limitations while gauging the suitability of convertible debentures. Subsequently, they should develop strategies to hedge the associated risks and increase income through investment in this debt instrument.