What is Convertible Debenture? Features, Types, Advantages & Disadvantages

Companies issue securities like debentures to acquire funds for operating their business or availing tax benefits. It is at the time of conversion that companies issue more shares, which reduces their cost of capital and their equity share value due to stock dilution. However, in this process, various types of debentures are offered as per their requirements, among which one is convertible debentures.

To learn more about what are convertible debentures, their types, features, benefits and others, read this piece until the end!

Convertible debentures are long-term debt instruments issued by companies to raise capital from the public in the face of a loan. These debentures hold higher popularity among investors because they are hybrid and can be converted to equity fully or partially. However, there is a specific period notified by companies only after which conversion of debentures is allowed.

Also, since these are unsecured bonds, it does not need any security backup to be kept as collateral. Other aspects of these debentures include they are liquid, have a higher yield and hold a scope of capital appreciation. Having said that, investors must remember convertible debentures earn comparatively lower interest than pure debt instruments. However, in return, it offsets the risk involved with securities to a certain limit.

The following are the features of convertible debenture that an investor can expect to notice:

• Conversion Ratio

This ratio indicates how many equity shares an investor has received against the number of convertible debentures he or she holds.

• Conversion Price

It is the actual shares issued and allotted by a company to a debenture holder. This conversion price can depend on many factors like market price, current book value, expected appreciation in the equity share value, and others. So, this conversion price can neither be too high nor too low. Also, a higher conversion price can result in compromised addition to the capital base. The price must be such that it allows investors to gain immediately from the conversion advantage.

• Convertible Value

A convertible value defines an investor's right to receive equity shares. Thus, one may need to multiply the conversion ratio by the current market price of a single equity share to set the value.

• Market Price

The market price of a convertible debenture depends on the investment value and conversion value of that debenture. Basically, it is the value market attaches to a convertible debenture.

• Quantum of Conversion

The number of debentures an investor can convert is expressed as a percentage of its face value. Further, the amount allowed for conversion is specified in terms of the number of equity shares per conversion rate.

• Coupon Payment

The value of a coupon depends on the credit quality of an issuer and the prevailing interest rate in the market. Moreover, per the set clause, a company must clear coupon payments either half-yearly or annually during the issue.

• Premium

It is the sum increase in the value of convertible shares from their initial conversion or investment value.

• Timing of Conversion

There is a period that companies set. Only after the expiry of this period their investors can convert their debentures into shares. This usually ranges from a year to 5, i.e., from the date of allotment.

Individuals can choose to invest in two types of convertible debentures. These include:

1. Fully Convertible Debenture

Those debentures whose entire value is convertible into equity shares are fully convertible debentures. However, one can do it after the expiry of a specific period and at a conversion ratio as decided at the time of issue and mentioned in their prospectus. Moreover, after the successful conversion process, the debenture holders automatically become the company's shareholders.

In addition, when looking at the interest accrual aspect, a fully convertible debenture carries a lower interest rate than non-convertible debentures. Also, this interest is payable only until the conversion is successful as per the transfer issue.

Mostly, those companies issue this type of debentures that have not yet established a performance record. It helps the company increase equity capital and attracts more investors.

2. Partially Convertible Debenture

Those debentures whose entire value is convertible into equity shares are fully convertible debentures. However, one can do it after the expiry of a specific period and at a conversion ratio as decided at the time of issue and mentioned in their prospectus. Moreover, after the successful conversion process, the debenture holders automatically become the company's shareholders.

In addition, when looking at the interest accrual aspect, a fully convertible debenture carries a lower interest rate than non-convertible debentures. Also, this interest is payable only until the conversion is successful as per the transfer issue.

Mostly, those companies issue this type of debentures that have not yet established a performance record. It helps the company increase equity capital and attracts more investors.

3. Partially Convertible Debenture

In partially convertible debentures, only a part of debentures is convertible to equity shares, i.e., after the expiry of a specific period. Moreover, as for the remaining portion, debenture holders can redeem them upon maturity. The company determines this ratio of conversion at the time of issue. After conversion, these debenture holders become the company's shareholders only up to the extent to which they could convert their debentures.

Mostly those companies issue these debentures that have an established track record. However, since these are not very popular among investors, they are able to raise only a limited amount of capital.

From a business perspective, it is profitable to deal in convertible debentures since it allows the raising of funds in the quickest and most feasible way possible. Moreover, with funds raised from the issue of convertible debentures, a company can easily plan its growth and bring profit to the venue.

In contrast, from an investor's point of view, they can expect these advantages:

• Convertible debenture holders are the first ones to receive a payment if a company's liquidation occurs.
• If the stock price of the issuer declines, investors have an option to hold onto their bonds till maturity.
• Investors earn a fixed interest rate and are also eligible to enter stock price appraisals.
• Since convertible debentures are hybrid investment instruments, investors enjoy the benefit of receiving a fixed interest payout and an option to convert the loan to equity when the stock prices are rising.

However, apart from knowing the advantages, an investor must also grab other information like the disadvantages associated with convertible debentures to get a clear picture.

Some of the drawbacks of convertible debentures that investors must be mindful of include:

• Investors may suffer shortcomings when comparing convertible debentures to traditional bonds due to lower interest rate accrual.
• There is an associated risk of company default where the company may not even pay the principal amount to its debenture holders.
• There is a possibility that the stock price of a company may reduce after conversion. In this case, investors may lose all of their invested money.

Investors must have a clear concept of convertible debentures, their features, benefits and downfalls while gauging the suitability of convertible debentures. It helps develop the right strategies to hedge risks and earn more profit through investment. However, to sum up, this debenture option is best for individuals looking for fixed interest payment with an opportunity to convert as per their requirements.