Convertible Debentures: Definition, Benefits and Limitations

Convertible debentures are considered a profitable investment option for most investors due to their potential for higher yields, liquidity, and capital appreciation. One of their key advantages is the ability to convert them into stocks after a certain period, offering flexibility and potential growth opportunities. 

This article explores convertible debentures in detail, helping you understand their benefits, risks, and impact on your investment strategy.

Definition of a Convertible Debenture

It is a long-term debt which can be converted into stocks after a specific period. Convertible debentures are unsecured bonds or loans, as no primary collateral is linked with the debt. 

Companies issue convertible debentures to raise capital, offering investors regular interest payments (coupons) and principal repayment upon maturity. The key advantage is the flexibility to convert them into equity, providing potential upside if the company's stock performs well.

Example of Convertible Debentures

Suppose an investor holds a ₹1 lakh convertible debenture with an annual interest rate of 3%. The conversion ratio is 1:20, meaning every ₹1,000 of debenture value converts into 20 equity shares at maturity.

One can make the conversion decision based on the market situation. If the share prices are high, then conversion is profitable. Conversely, if stock prices are not doing well, holding on to debentures is profitable. 

Types of Convertible Debentures

Below are the most important types of debentures that are convertible and their definitions:

Fully Convertible Debentures

It is a type of debenture with full convertibility that gives you the option to convert your entire debt holding to equity shares. Terms regarding conversions are specified during the issuance of the debentures. 

New companies or businesses usually offer a fully convertible debenture. Such an option is attractive to investors due to its higher interest rates and equity ownership. 

Partially Convertible Debentures

A debenture with partial convertibility has the features of both non-convertible and convertible debentures. The issuing companies allow only a part of the entire debenture for conversion at a specified time. 

The remaining part of such a debenture earns regular interest and you will get the principal amount upon maturity. Issuing companies determine the debt-to-equity conversion ratio based on tax considerations and capital structure strategies.

Comparison Between Fully Convertible and Partially Convertible Debentures

Find the detailed comparison between the two types of debentures:

Advantages of Convertible Debentures

Take a look at the advantages of a convertible debenture:

1. Fixed Interest

This type of debenture offers a fixed interest payment, much like a fixed deposit. However, in this debenture, the interest rate is higher than that of a fixed deposit.

1. Option to Convert

Another benefit of this debenture is its option for conversion. You can either hold on to a debenture or convert it depending on the market’s state. 

1. Equity Upside

The conversion option gives you the choice to convert your holdings into stocks allowing you to enjoy the benefits from equity's upside in the upcoming future.

1. Lower Risks

Holding direct stocks is prone to the risk of generating negative returns and susceptible to market volatility. These types of debentures offer a combination of fixed income and equity options, making it a better investment choice.

1. Preference

Preference or priority is another advantage of holding to a convertible debenture. In the event of liquidation or bankruptcy of a company, debenture holders get the early preference. 

Disadvantages of Convertible Debentures

Below are a few disadvantages of a convertible type of debenture:

1. Risks of Equity

The share prices are volatile. Therefore, in the case of a fall in share prices, your investment value can be reduced after conversion.

1. Lower Rate of Interest

As you get the option for conversion, the interest rate in this type of debenture is lower than other traditional debt instruments.

1. Default Risk

Unlike FDs, convertible debentures carry a default risk. This risk refers to the possibility that the issuing company may fail to make timely interest or principal payments, potentially resulting in financial losses for investors.

Important Terms to Know About Convertible Debentures

Here are a few important terms you should know about convertible debentures:

• Conversion Rate: It is a ratio, indicating the amount of equity shares received against one convertible bond.
• Conversion Price: It is the price at which an ordinary share gets issued and allotted to a debenture holder.
• Quantum of Conversion: It is generally the number of debentures to convert and is expressed in percentage of its face value.
• Coupon Payment: Depending on the issuers’ credit value quality and interest rate, the value of coupon payment is decided. 
• Conversion Timing: The specified time of conversion of debentures. It usually ranges between 1 to 5 years after the allotment date. 
• Premium: It is the difference between the price of a convertible security and the current price of an equity share in the market. 
• Interest: The interest rates on debentures vary across issuers and are determined at the time of issuance. These interest payments are typically made on an annual or semi-annual basis.

Final Word

Convertible debentures are popular among investors due to their fixed income and option to convert. However, unlike other traditional debt instruments, the interest rate is lower. Adding convertible debentures to your portfolio can provide a balanced mix of debt and equity exposure. Before investing, it is crucial to assess the issuer’s credibility, including factors like growth potential and credit rating.

You can start investing in convertible debentures through Stable Money. Simply download the Stable Money app, navigate to the bond section, and follow the instructions to begin your investment journey.