Define Convertible Debenture: Everything You Need to Know
To define convertible debenture may be useful for those pursuing alternate forms of business funding, as convertible debentures are one such means of doing so.3 min read
Convertible Debenture Overview
To define convertible debenture may be useful for those pursuing alternate forms of business funding, as convertible debentures are one such means of doing so. Convertible debenture is a kind of loan that can be changed into stock once an agreed upon time period has expired. As such, convertible debenture is a hybrid, half-stock, half-loan security. Often categorized as a soft loan, its purpose is to raise money to maintain or expand business operations at a considerably lower rate than might otherwise be possible, especially if conventional lenders want nothing to do with the business.
Convertible Debenture Characteristics
Convertible debentures share both equity-like and fixed-income characteristics. Their equity characteristics include:
- Gaining or losing value with the underlying stock. Value loss will only extend to the established bond-floor of the debenture’s bond-like attributes.
- Continuing to offer principal repayment and interest income as long as the company is in business.
- Being more sensitive to stock price changes than trades in line with common stock or interest rates when the stock price exceeds the conversion price, or is “at the money.” Here there will also be little downside protection.
- Being less sensitive to stock price changes when the stock price is lower than the conversion price, or “out of the money.” Here influence will come more from credit factors and interest rates.
- Being influenced by both interest rates and stock price when the stock price is in line with the conversion price, or “in the money.”
Fixed-income characteristics, on the other hand, include:
- Representing a loan to the issuing party that will be paid back when the loan reaches maturity.
- Offering regular interest income by coupon payments, as well as repayment of the principal upon maturity of the loan (although this will typically be at a lower rate than it would be for non-convertible bonds).
- In most cases, being unsecured against the assets of the issuer and not being rated by credit agencies.
Convertible Debentures vs. Bonds
The main advantage of convertible debenture against bonds is that they allow investors to take part in share price appreciation when the debentures are converted to shares. Bonds, on the other hand, are cheaper because of tax advantages on the interest payments.
Convertible Debentures vs. Equity
The main advantage of convertible debenture against equity is that debenture need not be paid back if the debenture holder converts it to common shares. On the other hand, equity need be paid back in any scenario, although the business issuing such equity must give up the equity’s value in ownership and future earnings in order to have this advantage.
Equity’s main downside is that there is no insurance for it if default should occur, and in general it costs more money to raise it. Also, for equity holders, should bankruptcy occur, any debentures will take precedence over equity as far as asset recovery is concerned. Debenture in turn is preceded by regular debentures and senior bonds, but it still has precedence over common stock.
Convertible Debenture Risks
Convertible debentures do carry some risk with them, as do any type of bond. Thus, convertible debentures are generally more appropriate for investors with moderate or high risk tolerance or a more diversified portfolio. Convertible debentures may also not be rated by credit agencies, so credit risk may have to be judged by considering the issuer’s creditworthiness as well as their likelihood of defaulting. Default occurs when a convertible debenture issuer cannot repay the principal and the interest. If this occurs, then the priority of the bondholder’s claim on the issuer’s assets will depend on where the convertible was placed in the capital structure: senior unsecured bonds and bank debt may take precedence, for example.
Another risk in convertible debentures involves interest rates, as the debenture’s value will fall if interest rates rise. This rise will in turn also reduce the convertible debenture’s downside protection. Conversely, when rates decrease, the debenture’s price will rise, which can lead to call risk, which is the risk that the debenture’s issuer will call in the debenture if it has a callable status.
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