Convertible debentures

A convertible debenture is a loan with an escape hatch into ownership.

Until the conversion date it behaves exactly like any other debt instrument: it pays a periodic coupon, it sits above equity in a winding up, and it has a stated redemption date. On that date, instead of paying the money back, the company hands over shares on terms everyone agreed to at the outset.

The investor accepts a lower coupon than a plain debenture would pay, because part of the return is expected to arrive as capital appreciation on the shares. The issuer gets cheap money it never has to repay in cash. Somebody does pay: the existing shareholders, whose stake is diluted when the new shares appear.

The issuer fixes the conversion terms at the time of the issue:

• the date on which conversion will be made;
• the ratio — how many shares per debenture;
• the price at which those shares are allotted, usually at a discount to the market price;
• the proportion of the debenture that converts, which is what gives the instrument its name — Fully Convertible Debenture (FCD), Partly Convertible Debenture (PCD) or Non-Convertible Debenture (NCD).

On a PCD the convertible part becomes shares; the non-convertible part is repaid in cash on maturity.

Because conversion dilutes existing holders, convertible debentures are normally issued on a rights basis or with the specific approval of existing shareholders, and the issue is governed by SEBI Regulations. The workbook notes they suit lower-rated issuers and high-growth companies — the equity sweetener buys down a coupon those issuers could not otherwise afford.

For the registrar, conversion is an allotment event: new shares are created, authorised capital headroom is consumed, the register and the demat credits are updated, and the debenture holders' register is closed out.

A mid-cap company issues 20 lakh FCDs of Rs 1,000 each — Rs 200 crore — carrying 6.5 percent, against 9.75 percent it would have to pay on straight debt. Each FCD converts after three years into 8 equity shares at Rs 125.

What the coupon saves the company:

Interest at 6.50%  = Rs 13.00 crore a year
Interest at 9.75%  = Rs 19.50 crore a year
Saving             = Rs  6.50 crore a year  → Rs 19.50 crore over three years

What the investor gets on conversion, if the share is at Rs 160 on the conversion date:

8 shares × Rs 160 = Rs 1,280 of stock for a Rs 1,000 debenture

What it costs the existing shareholders. The company had 20 crore shares; conversion creates 20,00,000 × 8 = 1.6 crore more:

New total = 21.6 crore shares
Existing holders fall from 100% to 20 ÷ 21.6 = 92.6%  → dilution of 7.4%

And the Rs 200 crore is never repaid in cash. That is the whole bargain in three numbers.

Chapter 4.2 (Convertible Debentures) with Chapter 3.4(i) as the debt-side treatment. The chapter's own sample question asks what happens to the non-convertible portion of a partly convertible debenture on maturity — it is repaid, by cheque, NEFT or IMPS. Expect also the reasoning question: why a convertible carries a lower coupon, and why it is issued on a rights basis.

• FCD, PCD, NCD differ only in the proportion that converts. An NCD never converts; on a PCD only part does, and the rest comes back as cash.
• The lower coupon is not a bargain for the investor — it is payment taken in the form of an equity option.
• Conversion increases share capital. The company saves the cash repayment, and the existing shareholders pay for it in dilution — which is why their approval, or a rights route, is required.
• A convertible is not a warrant. Exercising a warrant requires fresh money at the exercise price; conversion consumes the debenture itself.
• The conversion price is usually at a discount to the market price, so a question that sets it at a premium is describing an FCCB, not a domestic convertible.
• Convertibles are attractive to low credit rating and high-growth issuers; the presence of a convertible is not, on its own, a sign of strength.