Convertible Debentures Explained: Meaning, Types & Why Investors Like Them

Businesses constantly look for affordable ways to raise capital while balancing management control and financing costs. Similarly, portfolio investments require balancing equity and debt instruments for the right blend of risk and return. Let’s now understand the convertible debentures meaning in detail with examples and types. This article explains what convertible debentures are, their types and other key facts every investor must know.

What is a convertible debenture?

In their basic form, convertible debentures are long-term debt securities. They have a specific coupon rate and a maturity date. Coupon rates are essentially interest rates, which can be fixed or variable over the investment period. Companies issuing debentures are legally obligated to pay interests at predefined intervals and return the principal amount upon maturity. So, for investors, debentures act as fixed-income investments. However, the term ‘convertible’ adds an equity twist to the fixed-income nature of debentures. The ‘conversion clause’ allows investors to convert their debentures into equity shares of the issuing company. The conversion ratio, i.e. the number of equity shares investors receive upon exercising this option, is specified at the time of issuance. It is vital to understand that conversion is typically a right, not an obligation, for investors.

Types of convertible debentures

In general, there are four types of convertible debentures available in capital markets.

• Fully convertible (FCD)
  
• Partially convertible (PCD)
  
• Non-convertible (NCD) cum warrants
  
• Compulsory convertible (CCD)
  

Fully convertible debentures

These are debt instruments that allow the full principal amount to be converted into equity shares of the issuing company. The conversion ratio and the price at which conversion will occur are typically disclosed at the time of issuance. These instruments can offer excellent returns if the company’s shares perform positively in the stock market.

Partially convertible debentures

These allow only a portion of the principal amount to be converted into equity shares, while the remainder is repaid at maturity like a regular debt instrument.

NCDs with warrants

These are traditional debentures that cannot be converted into equity. However, the attached warrants give investors the right to purchase equity shares at a pre-specified price (known as the exercise price) and within a set timeframe. If the exercise price is higher than the market price, investors are unlikely to use the warrant, and the NCD behaves like a regular debenture.

Compulsory convertible debentures (CCD)

These debentures are less common. Investors in this type of debenture instrument may have an obligation to convert the principal amount to equity.

Benefits for issuing companies

From the issuer’s perspective, raising capital through convertible debentures offers several advantages:

• Lower interest costs: Investors accept convertible debentures at lower interest rates than regular debt instruments. The reason is the dual benefits of assured return through interest payments and the opportunity of future capital appreciation through equity conversion. This helps companies raise debt capital at lower costs.

• Delayed dilution of existing shareholders’ stake: Conversion into equity typically occurs at maturity and only if share prices appreciate, delaying and possibly minimising dilution. Appreciation in share price leads to an increase in the company’s valuation. So, diluting existing shareholders’ stakes through debenture conversion happens only at a higher valuation.

• Appealing to a wide variety of investors: The conversion clause makes debentures attractive to investors with an appetite for high risks. On the other hand, an assured fixed income stream from debenture without any obligation to convert also makes these instruments appealing to investors with a moderate risk profile.

• Ability to signal strong growth potential: A company capable of attracting investments through convertible debentures signal its credibility among investors for strong growth potential. This can help build the company’s brand presence.

• Tax efficiency: Companies can deduct interest paid on debentures as an expense. It helps them reduce their tax liability on corporate income.

Benefits for investors

Convertible debentures offer several advantages for investors:

• Safety of fixed-income assets: Companies are under legal obligation to make interest payments and payout the principal amount at maturity. So, these instruments are inherently fixed-income investments with assured downside protection for the invested capital.

• Growth potential of equity: If investors choose to fully or partially convert debentures into equity shares, the opportunity for capital gain is potentially endless. So, these instruments can offer the best of both worlds—assurance of fixed income and a capital gain of equity.

• Regular flow of interest income: Convertible debentures assure period interest payments acting as an alternative source of earning. Investors looking for a regular income stream may also find convertible debentures attractive.

• Flexibility about conversion: Generally, the conversion clause is not an obligation for investors. It offers a right to convert. Only interested investors may exercise their right to convert their principal amount to equity shares. So, if companies’ shares are not performing well, investors may choose to claim the principal amount back.

• Tax benefits: Conversion of debentures to equity shares does not attract taxes for investors, unlike payment of STT for purchasing shares from markets. This can lead to considerable savings.

Things to consider while investing in convertible debentures

In addition to knowing convertible debentures’ meaning, investors must be careful about the following factors if they choose to invest in such instruments.

• Conversion ratio
  
• Maturity date
  
• Interest rate
  
• Prevailing market interest rates
  
• Conditions of conversion
  
• Stock market sentiment
  
• Financial fundamentals of the issuing company
  

Conclusion

A well-structured convertible debenture can be a win-win for both the issuing company and investors. However, it is essential to perform due diligence regarding the issuing company’s financial health and growth prospects. Investing in debentures of financially unstable companies may not be a wise decision.

Sources

Investopedia
Cleartax
S&R Associates Advocates
Acuity Law