Convertible Debenture: Definition, Example, Advantages & Risks

What Is a Convertible Debenture?

A convertible debenture is a type of long-term debt issued by a company that can be converted into shares of equity stock after a specified period. Convertible debentures are usually unsecured bonds or loans, often with no underlying collateral backing up the debt.

These long-term debt securities pay interest returns to the bondholder like any other bond. The unique feature of convertible debentures is that they are exchangeable for stock at specified times. This feature gives the bondholder some security that may offset some of the risks involved with investing in unsecured debt.

A convertible debenture differs from convertible notes or convertible bonds, generally in that debentures have longer maturities.

Convertible Debentures Explained

Typically, companies raise capital by issuing debt, in the form of bonds, or equity, in the form of shares of stock. Some companies may use more debt than equity to raise capital to fund operations or vice versa.

A convertible debenture is a type of hybrid security with characteristics of both debt and equity instruments. Companies issue convertible debentures as fixed-rate loans, paying the bondholder fixed interest payments on a regular schedule. Bondholders have the option of holding the bond until maturity—at which point they receive the return of their principal—but, holders may also convert the debentures into stock. The debenture can typically only be converted into stock after a predetermined time, as specified in the bond's offering.

A convertible debenture will usually return a lower interest rate since the debt holder has the option to convert the loan to stock, which is to the investors' benefit. Investors are thus willing to accept a lower rate of interest in exchange for the embedded option to convert into common shares. Convertible debentures therefore allow investors to participate in share price appreciation.

Special Considerations

The number of shares a bondholder receives for each debenture is determined at the time of issue based on a conversion ratio. For example, the company might distribute 10 shares of stock for each debenture with a face value of $1,000, which is a 10:1 conversion ratio.

The convertible debt feature is factored into the calculation of the diluted per-share metrics of the stock. The conversion will increase the share count—number of shares available—and reduces metrics such as earnings per share (EPS).

Another consideration for investing in unsecured debentures is that in the case of bankruptcy and liquidation they receive payment only after other fixed-income holders.

Types of Debentures

Just as there are convertible debentures, there are also non-convertible debentures whereby the debt cannot be converted into equity. As a result, non-convertible debentures will offer higher interest rates than their convertible counterparts since investors do not have the option to convert to stock.

Partly-convertible debentures are also a version of this type of debt. These loans have a predetermined portion that can be converted to stock. The conversion ratio is determined at the onset of the debt issuance.

Fully-convertible debentures have the option to convert all of the debt into equity shares based on the terms outlined at the debt issuance. It's important that investors research the type of debenture they're considering for investment including if or when there is a conversion option, the conversion ratio, and the time frame for when a conversion to equity can occur.

Benefits of Convertible Debentures

As with any fixed-income instrument, whether it is a bond or loan the debt it represents ultimately needs to be repaid. Too much debt on a company's balance sheet can lead to high debt-servicing costs that include interest payments. As a result, companies with debt can have volatile earnings.

Equity, unlike debentures, does not require repayment, nor does it require the payment of interest to holders. However, a company might pay dividends to shareholders, which although voluntary, could be seen as a cost of issuing equity since the firm's retained earnings or accumulated profits would be reduced.

Convertible debentures are hybrid products that try to strike a balance between debt and equity. Investors gain the benefit of fixed interest payments while also having the option to convert the loan to equity if the company performs well, rising stock prices over time.

The risk to investors is that there is little insurance in case of default if they're holding shares of common stock. However, during bankruptcy liquidation, if an investor is holding a convertible debenture, the debenture holder gets paid before common shareholders.

Real-World Example of a Convertible Debenture

Assume Pear Inc. wants to expand internationally for the first time to sell its mobile products and services. Investors are unsure if the products will sell abroad and whether the company's international business plan will work.

The company issues convertible debentures to attract enough investors to fund their international expansion. The conversion will be at a ratio of 20:1 after three years.

The fixed interest rate paid to investors on the convertible debenture is 2%, which is lower than the typical bond rate. However, the lower rate is the trade-off for the right to convert the debentures into stock.

Scenario 1:

After three years, the international expansion is a hit, and the company's stock price takes off rising from $20 to $100 per share. Holders of the convertible debentures can convert their debt into stock at the 20:1 conversion ratio. Investors with one debenture can convert their debt into $2,000 worth of stock (20 x $100 per share).

Scenario 2:

The international expansion fails. Investors can hold on to their convertible debentures and continue to receive fixed interest payments at the rate of 2% per year until the debt matures and the company returns their principal.

In this example, Pear got the benefit of a low-interest-rate loan by issuing the convertible debenture. However, if the expansion does well, the company's equity shares would get diluted as investors convert their debentures to stock. This increase in the number of shares would result in a diluted earnings-per-share.