With reference to Convertible Bonds, consider the following statements:As there is an option to exch

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?

Accepted Answer

A convertible bond is a fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. It offers investors a type of hybrid security that has features of a bond, such as interest payments, while also having the option to own the underlying stock.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.However, 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 common stock. Companies benefit since they can issue debt at lower interest rates than with traditional bond offerings. However, not all companies offer convertible bonds. Hence statement 1 is correct.The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices. 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. Hence statement 2 is correct.Source Attribution: Investopedia, The Economist