Convertible debt in the form of convertible debentures and convertible bonds are a significant source of income for companies. With businesses seeking to expand and grab market share at breakneck speeds, or even just recover post the pandemic, credit is sorely needed and convertible debt instruments provide an effective mechanism for sourcing the same.
But what are convertible debentures, convertible bonds and why are companies inclined to offer them in recent years? Let’s find out.
Debentures are a debt instrument that are offered by firms in order to fund their business (or a number of other goals) and are a form of unsecured debt. Meaning, unlike bonds, debentures are not backed by any physical asset of the firm and are issued solely on the creditworthiness of the issuer. Meaning, if the company were not able to repay their debt, there would be no physical asset that the lender could demand be liquidated in order for them to be paid back. Convertible debentures are similar debt instruments, with the single additional clause of the debentures being converted into equity stock in the company after a given time.
Similar to debentures, bonds are also a debt instrument and are issued by companies and firms to raise additional funds from the public. Unlike debentures however, bonds are a form of secured debt, meaning that in the case of non-repayment, physical assets of the company can be liquidated to repay the amount. Convertible bonds also function in an identical manner to convertible debentures. Issued as a bond, they can be converted into equity stock after a certain stipulated period.
Why do companies issue convertible bonds and debentures?
Generally, convertible bonds are offered by companies that predict growth at a rapid pace but have a less than optimum credit rating. This scenario offers a number of benefits to both parties. For firms looking to raise capital, issuing convertible bonds allows them to raise capital at a lower cost than what traditional bonds would have cost them. This is due to the nature of the bonds allowing them to be converted to stock or cash at certain points in times. For the lender, convertible bonds are a stellar opportunity to retrieve some interest payments while still keeping their avenues open for entry into the company as an investor if they expect the stock price to rise and wish to capitalise on it. For instance, a lender would take 70% interest payments compared to traditional bonds but would have the option to convert those bonds into stock when the price rises, allowing them to mitigate that risk and capitalise on the opportunity cost.
For investors, buying convertible debentures helps offset the primary drawback of debentures: their unsecured nature. If for instance, a company is not able to repay debt acquired through traditional debentures, the lender will have no practical way to regain their money and will be left with a loss. However, if they possess convertible debentures, they could opt to convert their debentures into company stock and offload those shares to regain at least some part of their investment, more than they would have received with traditional debentures.
Firms also benefit from issuing convertible debentures. The fact that they have to offer lower interest payments aside, it also helps the company to save on cash. How? If a firm issues a certain number of traditional debentures, upon maturing, they would have to repay the lenders in cash. However with convertible debentures, some lenders might opt to trade their debentures for stake in the company, meaning that the company does not have to make cash payments to this lender. The flipside however, is that if too many lenders choose to trade their debenture coupons for stock, it could dilute the share price of the company.
Convertible bonds and convertible debentures are an excellent way for companies to raise funds from the public at a lower rate than they would have to pay. While this is good for companies looking to save some cash, this is especially good for companies that are relatively new or have limited revenue, making it difficult for them to raise capital at market rate. In this situation, convertible bonds and convertible debentures allow companies to raise required capital without risking financial instability or inability to repay debt.