With reference to Convertible Bonds, consider the following statements

With reference to Convertible Bonds, consider the following statements :

As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
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 ?

1 only

2 only

Both 1 and 2

Neither 1 nor 2

Answer is Right!

Answer is Wrong!

This question was previously asked in

UPSC IAS – 2022

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Statement 1 is correct: Convertible bonds give the holder the option to convert the bond into a specified number of shares of the issuing company’s common stock. Because this conversion option offers potential upside (participation in stock price appreciation), investors are typically willing to accept a lower interest rate (coupon) on a convertible bond compared to a traditional non-convertible bond issued by the same company with similar maturity and risk profile. Statement 2 is incorrect: The option to convert to equity provides potential linkage to the *stock price* performance, not directly to rising consumer prices (inflation). While equity values *can* over the long term reflect or hedge against inflation, the conversion option itself is not a form of indexation to consumer price levels. A CPI-linked bond would provide direct indexation to rising consumer prices.

Convertible bonds are hybrid securities that combine features of both debt (interest payments) and equity (conversion option), offering potential capital appreciation in exchange for a lower yield.

The conversion ratio (number of shares per bond) and conversion price are set at the time of issuance. Investors might convert the bond into stock if the stock price rises significantly above the conversion price, making the value of the stock received upon conversion greater than the bond’s value.

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