1. As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
2. The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.
Which of the statements given above is/are correct?
Explanation
Statement 1 is correct: A convertible bond is a fixed-in-come corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. Convertible bonds generally offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock. Investors will generally accept a lower coupon rate on a convertible bond, compared with the coupon rate on an otherwise identical regular bond, because of its conversion feature.
Statement 2 is correct: Equity (stock) prices tend to rise with inflation. Companies’ earnings and assets often appreciate during inflationary periods. Therefore, the option to convert a bond into equity provides a hedge against inflation. If inflation rises and the company performs well, its stock price is likely to increase. The bondholder can then convert the bond into equity at a more favorable price, thus benefiting from the rising prices and protecting their investment’s real value (purchasing power). This acts as a form of indexation (linking to a price index) against inflation.