Investors looking to diversify their portfolio with minimal risk for their investment often opt for convertible debentures.
Convertible debentures are debt investment instruments that allow companies to raise money by selling bonds, which can be converted into shares on a fixed date.
On the investor’s end, these are popular debt instruments thanks to their low-risk profile. It goes without saying that if you are a risk-averse investor, convertible debentures can be a good option.
They can help you keep your money secure and earn a fixed rate of interest, all while giving you the option to participate in the company’s future performance.
In this article, we will provide a detailed understanding of convertible debentures.
Debentures and Their Different Kinds
Let us start at the very basics and understand what debentures are.
Debentures are a type of debt instrument issued by companies to raise capital.
While debentures are mostly issued by companies to raise capital, government or quasi-government agencies may also issue them.
You will find two kinds of debentures in the market: convertible and non-convertible.
Convertible debentures can be converted into equity shares or other securities at the option of the company or the debenture holder, while non-convertible debentures do not have this conversion option.
What is a convertible debenture?
Convertible debentures, or CDs, are a type of debt security that allows you to convert the principal amount into common shares or other securities after a specified period.
If you do not want to take any risk with your money and have a longer time horizon for your investment, these debentures are a great choice. It offers flexibility as well as upside potential.
So, what are your earnings when you invest in a convertible debenture?
You will get fixed interest at a rate conveyed to you at the beginning. This interest will be paid to you until the maturity of the debenture.
Upon the expiration of a specific period, you will be given the option to either take your principal back or convert it into the company’s stock.
This specific period will be conveyed to you at the beginning of the purchase.
However, due to their convertibility, convertible debentures have lower interest rates than typical bonds. Therefore, this instrument is beneficial for you, if you want to enjoy the option of conversion to shares in the future.
If you are a risk-averse investor focused on earning interest and keeping your investment safe, you might want to look at bonds instead.
How Does a Convertible Debenture Work?
Convertible debentures typically have a term of five to seven years, after which they can be converted into shares.
The conversion ratio, or the number of shares per debenture, is set at the beginning itself, when the paper is issued.
For example, let us suppose ITC Ltd. issues 100 convertible debentures with a conversion ratio of 1:10.
Hence, each debenture can be converted into 10 shares. Thus, if you buy 100 convertible debentures, you will receive 1000 shares of ITC Ltd. on a specific date.
This conversion is done at a predetermined price, which is also communicated while issuing the debenture itself.
If the company’s stock price rises above the conversion price (the price at which the debenture is converted into shares), it will be immensely profitable to you. You can convert your money into shares at a profit.
However, the reverse is also true. If the stock price falls below the conversion price, you might have to face a loss if you plan to sell the shares immediately.
This is one of the risks of investing in CDs. You should hold on to the stocks and wait for the price to rise if you are not in a hurry to receive your investment back.
Another method by which you can earn from a convertible debenture is by selling it in the secondary debt market.
Due to their convertible nature, these instruments sell at a higher price in this market than their non-convertible counterparts.
What is a non-convertible debenture?
A non-convertible debenture, commonly known as an NCD, is a debenture that cannot be converted into equity shares of the company issuing the debenture.
Non-convertible debentures typically have a higher interest rate than CDs and have a more extended maturity date.
As a non-convertible debenture investor, you can receive periodic interest payments, known as coupons, until maturity. At maturity, you will receive your principal back.
There’s more! Some debentures may give you the option to invest your interest payments in cash or purchase additional NCDs instead. This option is known as “rolling over.”
Rolling over is a great opportunity for you to compound your returns and earn more money.
However, keep in mind that this also increases their risk because you have to commit to holding the debenture for a longer time.
Features of a Convertible Debenture
When issuing a debenture, you first need a trust indenture. A trust agreement is a contract that governs the relationship between the issuing corporation and a trustee who manages the investor’s interests.
One of the first things you need to check before investing in a convertible debenture is the interest rate or coupon rate.
This is the interest the company will pay to you as a debenture holder of the company. CDs may have a fixed or floating coupon rate.
In some cases, a floating rate is tied to a benchmark, such as the yield on a 10-year Treasury bond.
The second important feature of a convertible debenture is its maturity date.
As the name suggests, this is the date on which the company will repay the debenture or convert the debenture into shares.
You should check this date before investing so that you know when you can expect to receive your principal back.
The next critical feature is the company and debentures’ credit rating.
Every company strives to maintain a good credit rating because this determines the demand for debt papers issued by them.
This credit rating is assigned by a reputable credit ratings agency such as CRISIL, CARE, ICRA, and others.
Investors are always looking for papers issued by companies with high credit ratings. Moreover, each debenture also has a specific credit rating.
Hence, you need to check the credit rating of the company as well as the debenture before investing your money.
Debentures have a long history in the financial world and are commonly used to fund the expansion and growth of companies. They can be a good addition to your portfolio and help you diversify your assets.