With reference to Convertible Bonds, consider pin the following statements:
- As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
- The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.
Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Explanation
- As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
- This statement is correct. Convertible bonds typically pay a lower rate of interest compared to regular corporate bonds. This is because convertible bondholders accept a lower coupon rate in exchange for the option to convert the bonds into equity shares in the future.
- The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.
- This statement is also correct. The ability to convert the bonds into equity shares provides the bondholder some protection against inflation. If inflation rises and equity prices increase, the bondholder can convert to equity and benefit from the share price appreciation.
In summary, both statement 1 and 2 are correct. Convertible bonds pay lower interest rates than regular corporate bonds due to the conversion option. And the conversion option provides some inflation protection by allowing conversion to equity shares whose prices may rise with inflation.
Learn more:
- Convertible bonds are hybrid securities that possess features of both debt and equity. They pay interest like regular bonds but also give the holder the option to convert into a fixed number of common shares in the issuing company.
- Companies issue convertibles to lower borrowing costs compared to regular bonds. Investors accept the lower coupon rate due to the conversion feature.
- Convertible bonds help companies raise capital without immediate equity dilution. Conversion to equity happens later at a higher share price if the company performs well.
- For investors, convertibles provide fixed income as well as the ability to benefit from share price appreciation if the stock performs well.
- Convertibles are suited for high growth companies as they allow participation in the equity upside while providing downside protection of bond interest and principal repayment.
- The conversion terms, including the conversion ratio and conversion premium, determine how favorable the conversion option is for bondholders.
- Companies may force conversion if the share price exceeds the effective conversion price. This limits the bondholders’ upside if the stock rallies strongly.
