Definition of Convertible Debentures With Example, Types, Advantages, Features, etc.

A debenture is a fixed-income debt instrument. There are two types of debentures: convertible debentures and non-convertible debentures. In this article, we will understand the meaning of convertible debentures. A convertible debenture is a hybrid financial instrument that gives you the best of both fixed income opportunities and a window for capital appreciation.

Convertible Debentures are the types of long-term fixed-income debt instruments issued by companies, these come with a choice to convert it into company stock over a specific time period. Think of it as a mix between a loan and owning a piece of the company. It starts as a loan but can become company shares.

When you have this loan, the company pays you regular interest, like a monthly allowance. But if the company’s stock becomes more valuable over time, you can switch your loan into owning some of that stock. So, you get both a steady income and a chance for more money if the company does well.

What is a Convertible Debenture?

A convertible debenture is a long-term hybrid debt instrument. A company can issue convertible debentures to raise funds for its working capital or expansion needs. Convertible debentures give you an option to convert your holdings into equity shares at a specified time. 

These schemes pay fixed interest at specified monthly, annual, or cumulative intervals. In addition, you can exercise the right to swap the holding with the company’s stock upon maturity.

The conversion factor is specific to every issue. Companies issue convertible debentures to take advantage of the tax benefits linked with the interest payments.

Usually, debentures do not have any collateral security. A convertible debenture reduces the risk involved in holding an unsecured debt investment since it gets converted into equity shares. The interest rates are generally lower than other debt instruments due to the equity conversion benefit.

Example of Convertible Debenture

Let us take an example and see how convertible debentures work: Suppose you hold convertible debentures of Rs. 1 lakh with an interest rate of 3% per annum. It offers a conversion to equity on maturity at a 1:20 ratio. It means that for every debenture of Rs. 1,000 denomination, you will get 20 equity shares.

The issuer decides the conversion ratio at the time of the debenture issue. You have the right to hold on to the debenture till maturity and not convert it into equity. It gives you a choice to decide depending upon the market factors. If the share price is high, conversion is profitable, and if the stock is not doing well, you can opt to not convert. Some of the risks associated with investing in unsecured debt are mitigated by providing the bondholder with this option.

Types of Convertible Debentures

There are two types of convertible debentures available to investors in this asset class:

1. Partially Convertible Debentures

A partially convertible debenture has features of both convertible and non-convertible debentures. Here, the company allows for the conversion of only a part of debentures to equity at a specified time. 

The remaining portion earns timely interest, and you get the principal amount on maturity. Partially convertible debentures help a company prevent dilution of equity. The issuer decides on the overall debt-equity mix with due consideration given to tax implications, and issues partially convertible debentures.

2. Fully Convertible Debentures

A fully convertible debenture gives you the option to convert the entire debt holdings into equity shares of the company at a specified time. The terms of conversion are specified at the time of debenture issue. Usually, companies that are new in business and do not have a long track record offer fully convertible debentures. This option is attractive to investors as it offers higher interest rates and equity ownership.

  Partially vs Fully Convertible Debenture  

Features of Convertible Debentures

Let us take a closer look at the key features of convertible debentures:

Rate of Conversion

The number of equity shares you receive after debenture conversion is the debenture’s conversion rate.

Cost of Conversion

The price of an equity share at which a debenture holding gets converted is the conversion price; the price is specified at the time of issue. The issuers arrive at a conversion price depending on a stock’s market price, book value, expected price movement, market sentiment, etc. Investors may not favour a high conversion price, but it keeps equity dilution low in the company’s books.

Convertible Value

The value you will receive after conversion is the number of equity shares times the current share price.

Quantum of Conversion:

The percentage of debenture holdings converted into equity shares is known as the quantum of conversion. The issuer specifies the quantum at the time of debenture issuance. The quantum is a percentage of the debenture’s face value.

Date of Conversion

The conversion date is the specified date when you can convert your debenture holding into equity shares. It depends on the tenure of the debenture and the terms of the particular debenture issue.

Interest

The interest on a debenture varies amongst issuers depending on their credit rating, performance track record, payment history, reputation, etc. The interest is specified at the time of issue and paid annually or semiannually. The coupon ceases once the debenture holding gets converted into equity.

Premium

A premium is the difference between the price of a debenture and the current price of an equity share in the market. It helps you decide the premium you will pay for a debenture compared to direct equity. The risk is lower in debentures, which give you a fixed coupon. Hence, the premium helps you weigh risk and return before investing.

Also Read: What are Equities? Types Features and Advantages of Equity Shares

Advantages of Convertible Debentures

You can take advantage of the hybrid nature of convertible debentures in the following ways:

Fixed Interest

Convertible debentures usually offer a fixed interest payout similar to fixed deposits. The rate of interest is usually higher than fixed deposits. It is suitable if you are looking for predictable returns.

Equity Upside

The most attractive feature of convertible debentures is the choice to convert your holding into equity. It allows you to benefit from equity’s upside potential in the future.

Option to Convert

You can choose to convert your holding into equity shares, but it is not an obligation. If you find the stock price unfavourable, you can hold the debenture to maturity and continue earning the interest income.

Lower Risk

Direct stock holding comes with a risk of market volatility and even negative returns. Convertible debentures offer the best of both worlds, fixed income and equity options.

Preference

Debenture holders get preference over equity in the event of bankruptcy and liquidation.

Limitations of Convertible Debentures

There are drawbacks that you must be aware of before investing in convertible debentures:

Lower Interest Rates

Due to the equity conversion option, interest rates on convertible debentures are lower than interest on traditional debt instruments issued by a company. Higher upside potential means lower fixed interest.

Equity Risk

Equity share prices can be volatile. If the share price falls, the value of your investment after conversion will also be reduced.

Default Risk

Debenture investments also carry default risk, unlike fixed deposits.

Investor Rights

In the event of liquidation, investors holding traditional bonds and debt instruments have the first right of claim on the company’s assets over convertible debenture holders.

Closing Thought

Convertible debentures present a great investment option to you. It gives you higher returns compared to traditional deposits. You can add it to your portfolio to have a flavour of debt and equity. Before investing, you should assess the issuer’s credibility by credit ratings, the company’s record, growth, etc. 

FAQs about Convertible Debentures