What is a Convertible Debenture
A convertible debenture is a type of loan issued by a company that can be converted into stock. Convertible debentures are different from convertible bonds because debentures are unsecured; in the event of bankruptcy, the debentures are paid after other fixed-income holders. 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).
BREAKING DOWN Convertible Debenture
Companies obtain capital by issuing debt, equity or a hybrid of the two. These instruments are used by companies to obtain the capital they need to grow or maintain the business. Some companies use more debt than equity to raise capital, or vice versa. Convertible debentures are a hybrid financial product with benefits of both debt and equity.
Benefits of Convertible Debentures Over Debentures and Bonds
The main advantage of bonds is they are cheaper than equity due to the tax advantages of interest payments. The problem with debt is it must be paid back, even in difficult times. In this way, companies with high debt levels also tend to have volatile earnings. In other words, debt can increase returns, but it comes with risk in the form of earnings volatility. Another issue with debt from the investor's perspective is returns are limited.
By contrast, convertible debentures are not quite as cheap as debt to raise capital, but they are cheaper than equity. Investors are willing to accept a lower rate of interest in exchange for the embedded option to convert to common shares. Convertible debentures also allow investors to participate in share price appreciation as debentures are converted into shares. The number of shares received for each debenture is determined at the time of issue and provided in the prospectus. For example, the company can distribute 10 shares of stock for every debenture with a face value of $1,000. This is a 10-to-1 exchange or conversion ratio.
Benefits of Convertible Debentures Over Equity
The main advantage of equity for a company is equity does not need to be paid back. However, the business owner gives up ownership and some portion of future earnings. The main issue with equity is it has no insurance in case of default and generally costs more to raise. In the event of bankruptcy, debentures take precedence over holders of common stock.
By contrast, convertible debentures do not have to be paid back if they convert to common shares. Convertibles are not as senior as bonds or regular debentures, but they are more senior than equity. If share prices fall in case of default, convertible debentures get paid before common shareholders.