Explain the Difference Between Convertible and Non-Convertible Debentures
Debentures, along with bonds, are some of the most popular debt instruments. When companies, and sometimes even the government, wish to raise public funds, they issue this instrument known as debentures.
Debentures are of different types, which are categorised based on convertibility, redeemability, and transferability. Based on convertibility, debentures are then further classified into the following two types – convertible and non-convertible debentures.
A partially convertible debenture is another lesser-known debenture type. In this type of debenture, the company that issues the debenture decides the percentage of the debenture, which may or may not be converted into company stocks.
Further in this article, we will look at the difference between convertible and non-convertible debentures. The comparison can be drawn based on different parameters, which are discussed below.
We can differentiate between convertible and non-convertible debentures on the following basis:
Six Main Differences Between Convertible and Non-convertible Debentures
Similarities Between Convertible and Non-Convertible Debentures
Besides the difference between convertible and non-convertible debentures, the similarity between convertible and non-convertible debentures is that they both are a kind of debt instrument. Both of these debentures act on the same line like a bond. Generally, companies or sometimes the government comes with debentures. If they want to borrow money from the public, they usually issue debentures.
Also, some debentures are a mix of convertible and non-convertible debentures. They are known as partially convertible debentures. In such debentures, the issuing company can command the percentages of the debentures, which may or may not be converted into company stocks.
Which is Better? Convertible or Non-Convertible Debentures?
If you understand the difference between convertible and non-convertible debentures, carefully assess your investment goals and financial portfolio before making any investment. Generally, finance experts suggest that it is best to put 5 to 10% of your portfolio in the convertible debentures and invest the remaining in the traditional bonds and other investment options.
The convertible debentures have lower interest rates than non-convertible debentures as the holders have the advantage of converting them into equity shares. But though the non-convertible debentures have a higher interest rate, they are considered risky than convertible debentures and bonds.
Hence a safer option for investing would be convertible debentures. But, if you want to have higher profits and are willing to take the risk, then non-convertible debenture is the right choice for you.
Importance of Debentures
Debentures are helpful in a lot of ways and can become one of your potential investments. Some of the significant advantages of debentures are as follows:
Helpful in Unstable Market Conditions: In depressed market conditions, debentures play an essential role in providing a reliable source of finance for a company and are beneficial to the investors.
Beneficial for the Company Issuing Debentures: Debentures provides long-term finance on easy and cheap terms. The cost of borrowing money through debenture is minimum as the cost of debt is lesser compared to the cost of equity or preference shares as the interest is tax-deductible.
Mobilisation of Investments: Debenture helps in the mobilisation of savings from the public, particularly from those investors who are opposed to the idea of taking risks.
The Compulsion of Creation of Debenture Redemption Fund in Case of any Misfortunes, Thus Reducing the Risks of the Holders: Debenture issuing company is obliged now to create a debenture redemption fund to protect the interest of debenture holders.
FAQs on Difference Between Convertible and Non-Convertible Debentures
1. What is the primary difference between convertible and non-convertible debentures?
The main difference lies in the conversion option. Convertible debentures can be exchanged for equity shares of the issuing company after a specific period at a predetermined rate. In contrast, non-convertible debentures (NCDs) cannot be converted into shares and are simply redeemed (repaid) on maturity, making them a pure debt instrument.
2. In simple terms, what is a debenture?
A debenture is essentially a long-term loan taken by a company from the public. It is a formal debt instrument that acknowledges the loan and promises to pay a fixed rate of interest for a specified period, before repaying the principal amount on a set date. Unlike shareholders, debenture holders are creditors, not owners, of the company.
3. What are Non-Convertible Debentures (NCDs) and who is eligible to invest in them?
Non-Convertible Debentures (NCDs) are pure debt instruments that do not have an option to be converted into company stock or equity. They carry a fixed interest rate and are repaid at the end of their tenure. As per regulations, NCDs can be bought by a wide range of investors, including resident individuals, banking companies, corporate bodies registered in India, and other unincorporated bodies.
4. Can you give a real-world example of how convertible and non-convertible debentures work?
Imagine Company XYZ needs to raise funds. It can do so in two ways:
With Convertible Debentures: An investor buys a debenture for ₹1,000 with a 7% interest rate, which can be converted into 10 equity shares after two years. If the company's share price soars, the investor can convert the debenture to profit from the valuable shares.
With Non-Convertible Debentures: An investor buys an NCD for ₹1,000 with a higher 9% interest rate. The investor cannot convert it. They will receive the fixed interest payments and get their ₹1,000 back at maturity, regardless of the company's stock performance.
5. Why would an investor choose a non-convertible debenture over a convertible one?
An investor might choose a non-convertible debenture primarily for the higher and more predictable returns. NCDs typically offer a higher fixed interest rate compared to convertible debentures. This appeals to risk-averse investors who prioritise a steady income stream over the potential, but uncertain, capital appreciation that comes from converting to equity shares.
6. From a company's perspective, what is the main advantage of issuing convertible debentures?
The main advantage for a company issuing convertible debentures is that they are cheaper and less dilutive initially. Companies can offer them at a lower interest rate because the conversion option is an attractive feature for investors. Furthermore, if the debentures are converted, it increases the company's equity base without requiring an immediate cash outflow for redemption.
7. How does the risk level compare between convertible and non-convertible debentures?
Non-convertible debentures are generally considered less risky in terms of market volatility, as their return is fixed. However, they carry a credit risk—the risk of the company defaulting. Convertible debentures have a lower interest rate and carry a market risk; if the company's stock performs poorly, the conversion option becomes worthless, and the investor is left with a sub-par return compared to an NCD.
8. Are all convertible debentures fully convertible into equity shares?
No, not necessarily. Convertible debentures can be either fully convertible or partially convertible. In a partially convertible debenture, only a portion of the instrument's value can be converted into equity shares. The remaining part is treated as a non-convertible portion and is redeemed in cash on maturity.
9. How do debentures, both convertible and non-convertible, differ from shares?
The fundamental difference is between ownership and creditorship.
Shares: Represent ownership (equity) in a company. Shareholders are owners and receive dividends, which are not fixed.
Debentures: Represent a loan (debt) to the company. Debenture holders are creditors and receive a fixed rate of interest.
A convertible debenture blurs this line by offering a path from being a creditor to becoming an owner.
10. What are the other main classifications of debentures besides convertibility?
Besides convertibility, the other main types of debentures are classified based on:
Security: Secured (backed by company assets) and Unsecured (backed only by the company's creditworthiness).
Redemption: Redeemable (repaid after a fixed period) and Irredeemable (perpetual, although uncommon now).
Record: Registered (holder's name is recorded in a register) and Bearer (transferable by mere delivery).
