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Everything You Need To Know About Convertible Debentures

Personal Finance
08-11-2023
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Convertible debentures are long-term debt instruments. Firms issue convertible debentures. It has one unique feature. They can be converted into equity shares.

Shareholders can convert debentures into equity shares. This conversion gives security to the holder. And this security can balance the risk of investing in unsecured debt.

The issuer often holds conversion rights. A debenture can be converted into stock or shares only after a certain decided time.

Note that Non-convertible debentures can’t be changed into equity or shares.

What are Convertible Debentures

Convertible debentures are unsecured loans or bonds. Often, there is no collateral as security. Firms issue long-term debentures to take advantage of tax benefits. They are issued as fixed-rate loans. The bondholder gets fixed interest based on a schedule.

Let us take an example. A company that has issued convertible debentures can claim tax deductions for interest paid to investors. These can be fully, partially, or optionally convertible.

The interest rate on convertible debentures is low. This is because it can be changed into stock for the investor’s benefit.

Difference Between Convertible and Non-Convertible Debentures

FactorsConvertible DebenturesNon-Convertible Debentures
Rate of InterestThe rate of interest is lower. This is because convertible debentures can be converted into shares or equity.The rate of interest is higher. This is because non-convertible debentures cannot be converted into stock.
Maturity ValueThe maturity value depends on the stock price of the company. If the stock price goes high, it can lead to poor returns.Non-convertible debentures have a fixed and decided value by the coupon rate. The returns are fixed for every quarter, biannually, or annually until maturity.
Impact of Market ConditionsConvertible debentures can be converted into equity stocks during unstable market conditions.Non-convertible debentures cannot be converted at any time. Non-convertible debenture holders have to wait until maturity for redemption.
StatusConvertible debenture holders can be creditors or shareholders in the company.Non-convertible debenture holders are always creditors or lenders.
RiskThere is a lower risk* in convertible debentures.There is a higher risk^ in non-convertible debentures.

* This is because the investor can convert them into shares.

^ This is because investors have to wait until maturity to redeem the value.

Types of Convertible Debentures

Convertible debentures are wholly or partially convertible.


Fully Convertible Debentures

  • The entire value can be changed to match the equity shares of the company.
  • The conversion of these debentures leads to higher equity capital.
  • These have a highly favourable debt-to-equity ratio.
  • They are classed as equity or stock.
  • The conversion ratio is decided at the time of issuing.
  • This is good for companies that do not yet have a good track record that is well known.
  • This is popular among investors.


Partly Convertible Debentures

  • Only a part can be converted into equity.
  • They have a favourable debt-to-equity ratio.
  • The convertible part is classed as equity.
  • The non-convertible part is classed as debt.
  • The conversion ratio is checked when the securities are issued.
  • Conversion leads to lower equity capital.
  • This is best for those companies that have a good track record.
  • This is not as common among investors.

Features of Convertible Debentures

These are some common features of convertible debentures.

Conversion Price

The conversion price is the price at which a usual share is issued.

These are then assigned to the holders. This price depends on various factors. This includes market price, current book value, and the expected rise in share value. A higher conversion price means lower inclusion to the capital base.

Conversion Rate

This shows the number of equity shares acquired in place of a convertible bond.

Quantum of Conversion

This is the number of debentures that has to be converted. It is shown as a percentage of the face value.

Coupon Payment

The value of a coupon payment depends on the issuer’s credit quality and interest rate. A study of the “break-even point” is useful to distinguish coupon payouts from dividend yields of common shares.

Convertible Value

The value is set on an investor’s right to receive equity shares. This value is received by multiplying the conversion ratio by the market price of each equity share.

Conversion Timing

The time ranges from one year (from the date when allotted) to five years.

Market Price

The market price depends on the investment and conversion value. The market price is the value that the market associates with a convertible debenture.

Premium

This is the difference between the current stock price and the conversion price.


Benefits of Convertible Debentures

From the point of view of business, convertible debentures are a quick and easy way of raising funds. These funds can speed up the growth and profit of a company.

These are some of the benefits of
convertible debentures.

  • Convertible debentures have a fixed rate. There is also the option to take part in the rise of stock prices.
  • If the price of the issuer’s stock decreases, investors can retain the bonds until maturity.
  • Convertible debenture holders are paid before other stockholders at the time of liquidation of the company.
  • This is a hybrid investment option. Investors receive fixed-interest payouts. They can choose to convert their loan to equity too. This is done when the stock prices are high or when the company is performing well.

Limitations of Convertible Debentures

Just like any other investment, there are also limitations. These are some disadvantages of convertible debentures.

  • Convertible debenture holders obtain a lower interest rate than other bonds.
  • The company’s actions may affect convertible debenture holders. In such cases, the company may not be able to repay the principal amount to the investors.
  • If the stock price decreases after the conversion into equity, investors may suffer losses in their investments.

Conclusion

Convertible debentures attract investors because they have fixed interest payments. If the share prices of the firm rise, the investors benefit. This is because of the pre-set conversion terms.

Investors can then buy shares at a discount with conversion. This depends on the terms of the contract. If the share price goes down, they can keep the security as a bond. In this case, they can earn higher interest than if they had bought traditional bonds.

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