What Is a Fully Convertible Debenture?

A fully convertible debenture (FCD) is a type of debt security in which the entire value is convertible into equity shares at the issuer's notice. The ratio of conversion is decided by the issuer when the debenture is issued. Upon conversion, the investors enjoy the same status as ordinary shareholders of the company.

KEY TAKEAWAYS

  • A fully convertible debenture (FCD) is a type of debt security in which the entire value is convertible into equity shares at the issuer's notice.
  • The main difference between FCDs and most other convertible debentures is that the issuing company can force conversion into equity.
  • Fully convertible debentures give investors a way to participate in the growth of a company while reducing short-term risk.
  • On the downside, firms are likely to force conversion when it is beneficial to existing shareholders rather than FCD investors.

Understanding Fully Convertible Debentures (FCDs)

A debenture is a medium to long-term debt instrument used by large companies to borrow money at a fixed rate of interest. This fixed-income security is unsecured, meaning there is no collateral pledged to guarantee the interest payments and principal repayments. Thus, a debenture is backed by the full faith and credit of the issuer. If the company defaults or goes bankrupt, the debenture holder will get the invested funds back only after all secured creditors are paid.

Fully convertible debenture holders could receive nothing if the issuer goes bankrupt.

A debenture can be nonconvertible or convertible. A nonconvertible debenture will not be converted into equity. It therefore commands a higher interest rate than convertible debentures. A convertible debenture can be converted into common shares of the issuing company after a predetermined time. This time is determined by the trust indenture. The convertible holder has the advantage of enjoying any share price appreciation of the company after conversion. As a result, convertibles are issued with lower interest rates than nonconvertible debentures.

At the time of issuance, the trust indenture highlights the conversion time, conversion ratio, and the conversion price. The conversion time is the period from the allotment date of the debentures. After that time has passed, the issuer can exercise its option to convert the securities. The conversion ratio is the number of shares each debenture converts into and can be expressed per bond or per 100 bonds. The conversion price is the price at which the debenture holders can convert their debt securities into equity shares. The price is typically more than the current market price of the stock.

The main difference between FCDs and most other convertible debentures is that the issuing company can force conversion into equity. With other types of convertible securities, the owner of the debenture may have that option. Unlike pure debt issues, such as corporate bonds, fully convertible debentures do not pose a credit risk for the issuing company because FCDs eventually convert to equity.

Fully vs. Partially Convertible Debentures

A convertible debenture can be partially or fully converted into equity. Partially convertible debentures (PCDs) involve redeeming a fraction of the value of the security for cash and converting the other part into equity. A fully convertible debenture (FCD) involves a full conversion of the debt security into equity at the issuer's notice. The full conversion of debentures to equity is a method used to pay off debt in kind with equity. This payment in kind eliminates the need to repay the principal with cash.

Benefits of Fully Convertible Debentures

Fully convertible debentures give investors a way to participate in the growth of a company while reducing short-term risk. In the years before conversion, holders of FCDs are entitled to receive a stream of interest payments. While usually lower than those for nonconvertible debentures, these payments come before any dividends to shareholders. What is more, FCD owners receive payment regardless of the profitability of the firm. For relatively illiquid long-term investments, that can be a substantial advantage.

Another benefit of fully convertible debentures is that they can help the issuing firm to survive difficult financial situations. If the company issues a large number of nonconvertible debentures that mature at a specific time, the firm could face a credit crunch if there is a recession at that time. With fully convertible debentures, the firm avoids having to come up with the money to repay the principal. Even better, the firm can force conversion and eliminate interest payments. Since FCD holders then become shareholders, they also ultimately gain if the company recovers.

Criticism of Fully Convertible Debentures

The most obvious downside of fully convertible debentures for investors is the ability of the issuing company to force conversion. Firms are likely to force conversion at times that are beneficial to existing shareholders rather than FCD investors.

Suppose that the trust indenture specifies that the issuing company has the right to convert the FCD to equity at 50% above the current price in five years. If the share price falls 50% because the business did poorly, then the company might need to improve cash flow as soon as possible. FCD investors will probably be forced to convert at a substantial loss as soon as the five years are up.

On the other hand, existing shareholders will not want to dilute their equity if share prices are three times higher because the business did well. The company might delay conversion as long as possible, perhaps until the need to improve cash flow arises during a recession. At that point, share prices are likely to be lower, limiting the gains of fully convertible debenture holders.