With reference to Convertible Bonds, consider the following statements: 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?

With reference to Convertible Bonds, consider the following statements: 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? Correct Answer  Both 1 and 2

The correct answer is Both 1 and 2.

Key Points

Convertible bonds

• A convertible bond pays fixed-income interest payments but can be converted into a predetermined number of common stock shares.
• It is a hybrid security that offers investors the best of both stocks and bonds.
• It typically carries lower interest rate payments than straight corporate bonds the savings in interest expense can be significant.
• Investors accept the lower interest payments because the conversion option offers the opportunity to benefit from increases in the stock price. Hence, Statement 1 is correct.
• Governments might use indexation as a way to potentially alleviate the negative effects inflation can have on the recipients of transfer payments and entitlements. Hence, Statement 2 is correct.
• Social Security payments, for example, are indexed to the annual increase in the Consumer Price Index.
• Issuing convertible bonds can help companies minimize the negative investor sentiment that would surround equity issuance.
• Each time a company issues additional shares or equity, it adds to the number of shares outstanding and dilutes existing investor ownership.
• The company might issue convertible bonds to avoid negative sentiment.
• Bondholders can, then, convert into equity shares should the company perform well.