Q. Convertible Bonds, consider the following statements:

  1. As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
  2. 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?

  • 1 only
  • 2 only
  • Both 1 and 2
  • Neither 1 nor 2

Answer: (c) Both 1 and 2

Convertible Bonds:
  • A convertible bond is a type of debt security that provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond’s lifetime. It is a hybrid security that possesses features of both debt and equity.
    • When issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles.
  • Advantages of investing in Convertible Bonds:
    • One of the advantages of convertible bonds is that the option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.
    • Lower interest payments: Generally, investors are willing to accept lower interest payments on convertible bonds than on regular bonds. Thus, issuing companies can save money on their interest payments.
    • Potential for capital appreciation: Convertible bonds offer the potential for capital appreciation if the underlying stock price rises. This is because convertible bondholders can convert their bonds into shares of stock at a predetermined price.
    • Income generation: Convertible bonds typically pay regular interest payments, which can provide investors with a steady stream of income.
    • Reduced risk: Convertible bonds are less risky than traditional stocks, as they offer the downside protection of a bond.This is because convertible bondholders are guaranteed to receive the principal investment back at maturity, even if the underlying stock price has fallen.
    • Diversification: Convertible bonds can help investors to diversify their portfolios. This is because convertible bonds have characteristics of both bonds and stocks, and they can therefore help to reduce overall portfolio risk.
    • Deferral of stock dilution: If a company is not willing to dilute its stock shares in the short or medium term but is comfortable doing so in the long term, convertible bond financing is more appropriate than equity financing. The current company’s shareholders retain their voting power and they may benefit from the capital appreciation of its stock price in the future.
Preferred Stocks
  • Preferred shares (also known as preferred stock or preference shares) are securities that represent ownership in a corporation, and that have a priority claim over common shares on the company’s assets and earnings. The shares are more senior than common stock but are more junior relative to bonds in terms of claim on assets.
    • Holding stock in a company means having ownership or equity in that firm. There are two kinds of stocks an investor can own: common stock and preferred stock.
    • Common stockholders can elect a board of directors and vote on company policy, but they are lower in the food chain than owners of preferred stock, particularly in matters of dividends and other payments. On the downside, preferred stockholders have limited rights, which usually does not include voting.
    • When a company is going through liquidation, preferred shareholders and other debt holders have the rights to company assets first, before common shareholders. Preferred shareholders also have priority regarding dividends, which tend to yield more than common stock and are paid monthly or quarterly.
  • Features of Preferred Shares:
    • Preference in assets upon liquidation: The shares provide their holders with priority over common stock holders to claim the company’s assets upon liquidation.
    • Dividend payments: The shares provide dividend payments to shareholders. The payments can be fixed or floating, based on an interest rate benchmark such as LIBOR.
    • Preference in dividends: Preferred shareholders have a priority in dividend payments over the holders of the common stock.
    • Non-voting: Generally, the shares do not assign voting rights to their holders. However, some preferred shares allow its holders to vote on extraordinary events.
    • Convertibility to common stock: Preferred shares may be converted to a predetermined number of common shares. Some preferred shares specify the date at which the shares can be converted, while others require approval from the board of directors for the conversion.
    • Callability: The shares can be repurchased by the issuer at specified dates.