Below, we’ll dive into why a company might issue convertible debentures instead of regular stocks or bonds. We’ll also discuss the pros and cons of convertible debentures from an investor’s perspective and provide resources you can use to help inform your decisions.
Definition and Examples of Convertible Debentures
A debenture is a type of corporate bond that’s unsecured, meaning it’s not backed by collateral. A convertible debenture allows investors to exchange their bonds for another type of security, usually shares of the company’s common stock. You may hear the terms “convertible debenture” and “convertible bond” used interchangeably. As with regular bonds, investors receive fixed interest payments called coupons. If investors don’t convert their bonds to shares, they’ll receive their principal investment back when the bond reaches its maturity date. But if the investor converts their debentures into company shares, they’ll no longer receive interest payments and instead will hold an equity stake. Some convertible debentures allow you to choose if and when to convert your bonds to company stock. But some only allow you to convert your securities at predetermined times. A convertible issuer can also require you to convert your debentures to shares in some situations. Convertible debenture prices move with the company’s share prices. If the share prices rise, so will the convertible’s price, and vice versa. Often, a bond contract will include a conversion ratio that states how many shares of stock you will receive when you convert the bond. For example, a contract may have a conversion ratio of 25:1, meaning a bond issued at a par value of, say, $1,000 could be converted into 25 shares of stock. In some cases, the bond contract also states the conversion price, which is the price at which the company is willing to trade shares of its stock in exchange for the debenture. Sometimes, the conversion price changes over time. For example, a contract could specify that a conversion price is $40 for the first two years, then $45 for the next two years, then $50 for two years after that.
How Convertible Debentures Work
Corporations often issue convertible debentures when they haven’t established creditworthiness, yet they’re believed to have high growth potential. Issuing convertible debentures often allows companies to raise capital faster than they could through conventional debt or equity financing. Companies can save money with this strategy because investors will generally accept lower interest payments compared to regular bonds in exchange for the benefit of the equity option. Convertible debentures also provide companies with some key advantages over issuing more equity. For one, companies can save on taxes by issuing debt instead of equity because interest payments made on debt are tax-deductible. Additionally, companies seeking to avoid share dilution in the near term may opt for convertible debentures, which can defer it until the bond is converted. When a company issues more shares, it results in dilution, which reduces the percentage of ownership each share represents. That can cause a stock’s value to drop.
Pros and Cons of Convertible Debentures
Pros Explained
Source of fixed income: Convertible debentures offer fixed interest payments called coupons. However, once you convert the debenture to equity, you no longer get interest payments.Opportunity to buy discounted shares: You can typically convert your bonds to shares at a discount to the market price. However, that can be a disadvantage to existing shareholders because as the company issues more equity, each share represents a smaller ownership stake.Less risky than equity: If the company’s share prices drop, you can continue to hold the security as a debenture, rather than converting it to shares, and receive fixed interest payments. Additionally, bondholders’ claims take precedence over shareholders’ claims during bankruptcy, making them less risky in the event of default.
Cons Explained
Lower interest payments: Because they include an equity option, the fixed interest payments you receive from convertible debentures are lower than traditional bond coupons. Risk of default: Secured creditors have the highest-priority creditor claims if a company files for bankruptcy. Debentures are a form of unsecured debt, so if you hold convertible debentures you would get paid only after secured debt is satisfied. Typically callable: Most corporate debentures are callable bonds, meaning the company can call back the bonds and force the conversion to company shares.
What It Means for Investors
As an investor, you may find convertible debentures appealing because they provide fixed interest payments. You can also benefit from any rise in the company’s share prices because the conversion terms are set in advance. If share prices increase, you’ll likely be able to buy shares at a discount with a conversion, depending on the terms of your contract. However, if share prices drop, you’ll likely see more benefit keeping the security as a bond. In the latter case, you probably would have earned more interest had you invested in a traditional bond. Companies are required to disclose financing, including the issuance of convertible debentures, on their Form 10-Q and 10K reports, along with interim Form 8-K reports. You can access these forms on the U.S. Securities and Exchange Commission’s (SEC) EDGAR database. This information may be important to investors because if you own stock in a company that issues convertible debentures, the conversion could reduce the value of your shares due to dilution.
