Previous Year Question
With reference to Convertible Bonds, consider the following statements:
As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.
Which of the statements given above is/are correct?
Only 1
Only 2
Both 1 and 2
Neither 1 nor 2
Correct Answer: C
Detailed Solution
Statement 1 is correct.
A convertible bond combines the characteristics of an ordinary debt security with an equity-conversion option. Subject to predetermined conditions, its holder may convert the bond into shares of the issuing company.
The possibility of benefiting from a future rise in the company’s share price gives the investor an additional economic benefit. Consequently, investors may accept a lower interest or coupon rate than they would demand on an otherwise comparable non-convertible bond.
The issuing company benefits from the comparatively lower interest cost. If conversion occurs, the company may also avoid repaying the corresponding principal in cash at maturity, although conversion can dilute the ownership of existing shareholders.
Statement 2 is correct.
The interest income from an ordinary fixed-rate bond generally remains constant. When consumer prices rise, the real purchasing power of that fixed income may decline.
A convertible-bond holder can convert the bond into equity according to the specified terms. If the company’s nominal revenue, earnings and share price rise along with inflation, the conversion option allows the bondholder to benefit from the rising equity value. In this limited sense, the bondholder receives a degree of indirect indexation to rising consumer prices.
This is neither complete nor guaranteed inflation protection. The share price also depends upon the company’s performance, market conditions, interest rates and other risks. The expression “a degree of indexation” is therefore important: it indicates only partial and potential protection.