Q65. 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?
a) 1 only
b) 2 only
c) Both 1 and 2
d) Neither 1 nor 2
Answer – C
- Statement 1 is correct: Issuing convertible bonds can help companies minimize negative investor sentiment that would surround equity issuance. Further, issuing convertible bonds can also help provide investors with some security in the event of default. A convertible bond protects investors’ principal on the downside, but allows them to participate in the upside should the underlying company succeed. Convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into a common stock. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature. This enables the issuer to save on interest expenses, which can be substantial in the case of a large bond issue.
- Statement 2 is correct: The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices as equity prices can differ widely from the given interest and the difference in that can be used as a hedge for inflation. As indexation will ensure that prices are adjusted with inflation over a period of time. With the help of indexation, bondholders will be able to lower their long-term capital gains (as their investment will be adjusted with inflation) even when converting bonds into equity, which brings down their taxable income.
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