What Is a Convertible Debenture?
A convertible debenture is a general obligation corporate bond that can be converted into common stock under certain conditions.
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Debenture Features
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Debentures are considered less secure than other types of corporate bonds because they are not secured by any specific assets of the corporation and are backed by the issuer's general credit. The owner of a debenture is considered a general creditor of the corporation, meaning that if the corporation is liquidated in bankruptcy, he gets to stand in line along with other general creditors to recover his investment. Because of the higher risk that debentures carry, investors demand a higher interest on them.
Convertibility
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Convertible bonds give holders the right to convert them into shares of stock after a certain date based on a specific formula.
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Convertible Debenture
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Convertible debenture is therefore a well-packaged product. Instead of paying a higher interest, the corporation offers investors in the debenture an opportunity to participate in the stock's future upside. Investors are willing to accept a little less interest income today for a chance of capital appreciation down the road.
Benefits
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Bond investors receive current income. If a corporation does well and its stock soars, bond investors do not get to participate in the upside. Convertibility gives them that opportunity. Corporations offer convertible bonds because convertibility allows them to pay less in bond interest and because when the bond is converted into stock they no longer have to pay any interest, which saves them money.
Example
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An investor buys a 5 percent, 20-year convertible debenture at face value---for $1,000. The debenture is convertible into 25 shares of common stock after five years. The stock is currently trading at $20. Five years later the stock trades at $50. The investor will have collected $250 in annual interest over the five years. If he exercises the right to convert, he will get 25 shares of stock trading at $50---for a total of $1,250. If he sells the stock right away on the open market, he will realize a capital gain of $250, in effect instantly getting another 5 years' worth of interest.
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