Convertible Debenture

A convertible debenture is a type of long-term debt issued by a company that can be converted into stock after a specified period. Convertible debentures are usually unsecured bonds or loans that pay interest to the bondholder or lender. However, convertible debentures can be converted to stock after a specific time period has passed.

Typically, companies raise capital by issuing debt or equity. Some companies use more debt than equity to raise capital to fund operations or vice versa.

A convertible debenture is a hybrid financial product with benefits of both debt and equity. Companies use convertible debentures as fixed-rate loans and pay fixed interest payments. However, the holders of the debenture have the option of holding the loan until maturity and receive the interest payments or convert the loan into equity shares. The loan can only be converted to stock after a predetermined time period has elapsed.

A convertible denture will usually have a lower interest rate since the debt holder has the option to convert the loan to stock. Investors are willing to accept a lower rate of interest in exchange for the embedded option to convert to common shares. Convertible debentures allow investors to participate in share price appreciation once the debentures are converted into stock. The number of shares received for each debenture is determined at the time of issue and is based on a conversion ratio. For example, the company might distribute ten shares of stock for each debenture with a face value of $1,000, which is a 10:1 conversion ratio.

The convertible feature is factored into the calculation of the diluted per-share metrics, which increases the share count and reduces metrics such as earnings per share (EPS). Debentures are paid after other fixed-income holders in the event of bankruptcy.

Just as there are convertible debentures, there are also non-convertible debentures whereby the debt cannot be converted into equity. As a result, non-convertible debentures usually offer higher interest rates than their convertible counterparts since investors don't have the option to convert to stock.

Partly-convertible debentures are loans whereby it's predetermined that only a portion of the debt can be converted to stock. The conversion ratio is determined at the onset of the debt issuance. Fully-convertible debentures have the option to convert all of the debt into equity shares based on the terms outlined at the debt issuance. It's important that investors research the type of debenture they're considering for investment including if or when there's a conversion option, the conversion ratio, and the time frame for when a conversion to equity can occur.

As with any debt instrument, whether it's a bond or loan, the debt needs to be repaid. Too much debt on a company's balance sheet can lead to high debt-servicing costs such as interest payments. As a result, companies with debt can exhibit volatile earnings.

Equity does not need to be paid back nor does it have interest payments. However, a company might pay dividends to shareholders, which although voluntary, could be seen as a cost of issuing equity since retained earnings or accumulated profits would be reduced.

Convertible debentures are hybrid products that try to strike a balance between debt and equity. Investors gain the benefit of fixed interest payments while also having the option to convert the loan to equity if the stock price rises over time.

The risk to investors is that there's little insurance in case of default if they're holding shares of common stock. However, if an investor is holding a convertible debenture, the debenture holder gets paid before common shareholders in the event of bankruptcy.

• A convertible debenture is a type of long-term debt issued by a company that can be converted into stock after a specified period.
• Convertible debentures are hybrid products that try to strike a balance between debt and equity.
• Investors gain the benefit of fixed interest payments while also having the option to convert the loan to equity if the stock price rises over time.

Let's say a U.S. company called Apple Inc (AAPL) wants to expand internationally for the first time to sell its mobile products and services. Investors are unsure if the products will sell abroad and whether the company's international business plan will work.

The company issues convertible debentures to attract enough investors to fund their international expansion at a ratio of 20:1 only to be converted after three years.

The fixed interest rate paid to investors on the convertible debenture is 2%, which is lower than the typical bond rate. However, the lower rate is the trade-off for the right to convert the debentures into stock.

Scenario 1:

After three years, the international expansion is a hit, and the company's stock price takes off rising from $20 to $100 per share. Holders of the convertible debentures can convert their debt into stock at the 20:1 conversion ratio. Investors with one debenture can convert their debt into $2,000 worth of stock (or 20 * $100 per share).

Scenario 2:

The international expansion fails. Investors can hold onto their convertible debentures and continue to receive fixed interest payments at the rate of 2% per year until the debt matures and is paid back by the company.

Apple got the benefit of a low-interest-rate loan by issuing the convertible debenture. However, if the expansion does well, the company's equity shares would get diluted as investors convert their debentures to stock, which would result in diluted earnings-per-share.