How to Define Convertible Debenture
A convertible debenture is a type of debt security that allows the holder to exchange, or convert, the market value of the security into shares of the issuing company's common stock. As an investment, a convertible debenture comprises low risk and the option to benefit from gains in the equity of the issuer, should the market climate permit.
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Debt Instrument
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The term debenture describes the debt instrument commonly called a bond. Debentures are characterized as having a long-term (greater than one year) maturity period during which interim (coupon) payments of interest are disbursed to the holder as an amortized percentage of the security's face, or par, value (usually denominated in $1,000.00 increments).
Function
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Debentures are issued by private and public entities as a way of raising funds. Debentures are a debt arrangement in which the issuer borrows money from those who purchase and hold the debentures issued. In return for lending cash to the issuer, as expressed by the par value of debenture purchased, holders are compensated with the coupon interest payments as well as the return, upon maturity, of the debenture's entire face value.
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Interest on Convertible Debentures
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The already low-risk level comprised in a convertible debenture is further offset by the holder's ability to exchange its value for shares of common stock. For this reason, the interest on convertible debentures is generally lower than that offered by non-convertible debentures. Interest is offered on a debt security as compensation for risk. In this instance, the convertibility is part of that compensation, offsetting the interest requirement.
Convertibility to Stock
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The principal feature of a convertible debenture is the built-in option to receive shares of stock, at the holder's discretion, in exchange for the item's market value at the time of exercise. The conversion to shares of stock is not one-for-one with the stock market price, but is actually administered at a higher (premium) price per share to the market price of the common stock. The reason for this is that the conversion of debt to shares lowers, or dilutes, the value of the issuer's common stock. In this sense, the premium conversion price is meant to stabilize the stock's market value in the face of the introduction of additional shares into the market.
Advantages
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The value of a convertible debenture, as with any debt security, is largely dependent on the prevailing level of interest rates. A rise in this interest rate level reduces the market value of debt securities, like debentures, which have a fixed interest rate. Since a rise in interest rates generally signals economic expansion and a bullish market climate, the issuer's stock is likely to experience parallel gains in the market. The convertibility feature allows the holder of a convertible debenture to take advantage of such stock gains, maintaining the value of his or her investment.
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