Convertible and Non Convertible Debenture
Convertible and Non Convertible Debenture are like bond, in the sense that they are ‘debt instruments’. If a corporate entity like a bank or a co-operative venture wants to borrow money, it issues debentures to the public. Not only corporations, but Governments can issues debentures too. What makes a debenture different from a bond is that it is not backed by any assets. There is no collateral or any physical asset like property, gold, mortgage against which this loan is issued. Debentures are only backed by the reputation or creditworthiness of the government or corporation. They are usually long term financial instruments and can be thought of as IOU cards issued by a reputed entity. There can be two kinds of debentures:
- Convertible Debentures: These can be converted into company stocks, the option of which lies with the holder of the debentures.
- Non Convertible Debentures: These cannot be converted into company stocks.
Let’s look at some of the key differences between Convertible and Nonconvertible Debentures:
Since convertible debentures can be converted into company stocks whenever the holder pleases, they tend to have lesser rate of return compared to nonconvertible ones.
On the other hand, nonconvertible debentures cannot be converted into company equity or stocks. This makes them riskier than bonds or convertible debentures. This is why, as compensation, the interest rates are higher than other debentures.
Risk for Holders
It is less risky to buy convertible debentures than nonconvertible ones. This is because, in case there is a down trend in the market and signs of volatility, you can always minimize risk and control damage by converting them into company stocks. This makes convertible debentures a safe option since they are priced at lesser than share value. Thus converting them to shares would mean profit for the holder. Once they are converted, they operate like any other shares and can be traded in the market for either profit or to cut losses.
Nonconvertible debentures are riskier to possess because in the case of market volatility, interest rates tend to rise, but the value of the debenture drops. The only option the holder has is to wait it out till the maturity period. Failure to pay the debenture at the end of the maturity period means that the issuer is bankrupt. In this case, the holder can seize proportionate assets of the issuer.
Further, there is the distinction between Callable and Puttable debentures. In the case of callable debentures, the issuing company can ‘call’ or buyback and repay the investors according to their convenience. In the case of puttable debentures, the upper hand lies with you – the investor. The investor can ask the company to redeem their debentures and pay back the principal investment.
Odd One Out
There also a third type of debenture called partially convertible debenture. In this case, the issuing company can dictate the percentages of the debentures which may or may not be converted into company stock.
Make sure you receive all the details from the issuer of the debentures, the nature of its convertibility and the risk percentages involved before investing in a debenture.