A company issues debentures to raise capital from the public as a loan. A company can issue any type of debenture based on its requirement. A convertible debenture is one among them, which is a hybrid debt instrument that strikes a balance between equity and debt. This debt instrument is where the company can convert into equity shares fully or partially. This article will discuss convertible debentures and their features, types, advantages, and disadvantages.
What is a Convertible Debenture?
A convertible debenture is a long term debt instrument issued by a company that can be converted into equity shares after a specific period of time. They can be partially, fully or optionally convertible. These debentures are unsecured bonds as there is no primary collateral linked to them.
Generally, companies issue these debt instruments to avail of tax benefits. For instance, when a company issues debentures, they can claim a tax deduction for the amount of interest payable to the holders.
A convertible debenture provides regular interest income through coupon payments and repayment of principal amount on maturity. The decision to convert these debentures into equity shares lies with the holder as they are the creditors of the company.
Sometimes, the company may also possess these conversion rights. Moreover, this gives the debenture holder some security as it may reduce the risk involved with investing in unsecured debt. Also, convertible debentures yield lower interest rates than other pure debt instruments.
Types of Convertible Debentures
The following are the types of convertible debentures.
Fully Convertible Debenture
The company can fully convert the whole value of these debentures into equity shares on the expiry of the specified period. The conversion ratio is decided at the time of issue in the prospectus. After converting these debentures into equity shares, the debenture holders automatically become the shareholders of the company.
Also, the interest will be payable only up to the date of conversion as per the transfer issue. Furthermore, fully convertible debentures carry a lower interest rate than a non-convertible debenture.
A fully convertible debentures is suitable for companies that do not have an established track record. Also, this conversion leads to an increase in equity capital. Moreover, these instruments are quite popular among investors.
Partially Convertible Debenture
The company can convert only some portion of these partially convertible debentures into equity shares of the company on the expiry of the specified period. The remaining portion the holders can redeem at maturity as per the maturity period. The ratio of conversion is decided at the time of issue. After converting these debentures partially, the debenture holders can become the shareholders of the company to the extent of their holdings.
This instrument is suitable for companies with an established track record. The conversion also leads to lower equity capital. Thus, they are not very popular among investors.
Features of a Convertible Debentures
The following are the prominent features of a convertible debenture –
It is the actual share at which the company issues and allots to the debenture holder. There are several factors that determine the conversion price. Some of them are the current book value, market price, expected appreciation in the value of equity shares, etc. Thus, the company should not set the conversion price too low or too high. They should set at a level so that the investors gain immediately from the conversion privilege.
The conversion ratio is the number of equity shares that the holder receives in exchange for a convertible debenture.
Quantum of Conversion
The number of debentures to convert is specified in the terms of percentage of its face value. Further, the amount to be converted is translated into the number of equity shares based on conversion price.
The conversion value is dependent on the investor’s right to receive equity shares. Thus, to arrive at the convertible value, they have to multiply the conversion ratio by the current market price per equity share.
Time of Conversion
It varies depending on the time period of debenture, which usually ranges between one year from the date of allotment to five years.
The coupon payments depend on the company’s credit quality and the prevailing interest rate. As per the clause during the issue, the company pays the coupon payments half-yearly or annually.
The conversion value and investment value helps to determine the market price of the convertible debenture. Thus, this instrument is a combination of bonds and an option to buy a company’s equity share.
The amount by which the convertible debenture is higher than its conversion value or investment value. Thus, an investor can choose a convertible debenture over an equity share to reduce the overall risk.
Advantages and Disadvantages of Investing in Convertible Debenture
The following are the advantages and disadvantages of Investing in Convertible Debenture
|Investors receive fixed interest payments called coupons.||The holders no longer receive interest payments once the debenture is converted into equity.|
|If the company’s stock prices are declining, the bondholders can continue to hold the security until maturity.||Convertible debentures receive lower interest payments compared to other traditional debt instruments.|
|In the event of liquidation, the bondholders of convertible debentures are paid before the shareholders.||In case of bankruptcy, secured creditors are paid on priority. Thus, the convertible debenture holders will be paid only after secured debt holders are satisfied.|
|Being a hybrid instrument, investors receive fixed interest payments and can convert their loan into equity when the company is performing well or when stock prices are increasing.||After converting debentures into equity shares, the investors could lose their money if the company stock prices decline.|
Therefore, you must weigh the benefits and limitations to get a better picture while investing in convertible debentures. Subsequently, you can develop an investment strategy to account for the risk associated with these investments and take a proper decision.