Convertible Bonds UPSC pre 2022

 This was a tough question because statement 2 uses the word Indexation which many aspirants were not able to understand.

 

With reference to Convertible Bonds, consider the following statements : [2022]

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?

(a)        1 only

(b)        2 only

(c)        Both 1 and 2

(d)        Neither 1 nor 2

 

 

Solution: (c)

 

What are Convertible bonds?

 

They are hybrid securities that offer investors the best of both stocks and bonds.

 

Like any other kind of bond, they provide a guaranteed income stream and pay back the amount you originally lent the company.

 

Statement 1 - As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.

 

Convertible bonds typically carry lower interest rate payments than straight corporate bonds. So, they can lead to savings in interest expense.

 

Investors accept the lower interest payments because the conversion option offers the opportunity to benefit from increases in the stock price.

 

Statement 2-The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.

 

What is Indexation?

 

a system in which the value of something changes in relation to another value or fixed standard.

 

E.g. “Inflation-Indexed Bonds (IIBs)”

 

Indexation of pay rises to productivity will give people an incentive to work harder.

 

Governments might use indexation as a way to potentially alleviate the negative effects inflation can have on the recipients of transfer payments and entitlements.

 

Social Security payments, for example, are indexed to the annual increase in the Consumer Price Index.

coming back to the statement 

When Inflation is high but the interest rate on the bond is low then bondholders can convert it to equity if there is a chance of a better dividend from the company.

Therefore convertible bonds give a bondholder a degree of indexation to rising consumer prices or in simple words a method to fight inflation.