Compulsory Convertible Debenture

Introduction

Compulsory convertible debentures (CCDs) are becoming increasingly a popular method by companies to raise capital. They are a unique financial instruments that combines debt and equity features, providing investors with a steady stream of interest payments while offering the potential for capital appreciation.

Define Compulsory Convertible Debenture

A compulsory convertible debenture is a financial instrument issued by companies to raise capital. It is a type of debt security converted into equity shares at a predetermined time or when certain conditions are met. As the name suggests, converting the debenture into equity shares is mandatory.

Overview of Compulsory Convertible Debenture

CCDs are typically issued by companies that want to raise capital but want to wait to dilute their equity. This instrument comes with mixed features of debt and equity. This facility provides the company with a source of debt financing, preventing them from shelling an extra dollar from their reserves.

This can benefit companies in a growth phase and need to raise capital but do not want to dilute their equity. CCDs have a fixed interest rate, which is paid to the investor regularly, usually semi-annually or annually.

The debenture is converted into equity shares at a predetermined price at the end of the specified conversion period or when the conditions are met. The price of this hybrid instrument is usually determined at the time of issuance.

Reasons Companies Issue Compulsory Convertible Debentures

There are several reasons why companies may choose to issue compulsory convertible debentures. One reason is that it allows them to raise capital without immediately diluting their equity. This is particularly beneficial for companies in a growth phase that need to raise capital but do not want to dilute their equity.

Companies issue CCDs because they are an attractive option for investors. They offer a higher yield than traditional equity investments while providing the potential for capital appreciation. Additionally, CCDs can be an effective way for companies to manage their debt-to-equity ratios, treating them as equity on the balance sheet.

Pros and Cons of Compulsory Convertible Debenture

One of the main advantages of CCDs is that they provide companies with a source of debt financing while also allowing them to convert the debt into equity later. This can benefit companies that want to raise capital but want to wait to dilute their equity.

Another advantage of CCDs is that they can be attractive to investors. This is because they offer a higher yield than traditional equity investments while providing the potential for capital appreciation.

However, there are also some disadvantages to CCDs. One disadvantage is that they can be complex financial instruments that require a high level of understanding. Additionally, CCDs can be less liquid than traditional equity investments, meaning that investors need to wait for a period to attain funds upon conversion.

Trading of Compulsory Convertible Debentures

CCDs can be traded in the open market like any other financial instrument. However, the liquidity of CCDs can vary depending on the issuer, the terms of the debenture, and the market conditions.

Generally, CCDs have lower trading volumes than traditional equity or debt instruments. This is because converting CCDs into equity shares is mandatory, which means that investors may be less inclined to trade the debentures in the open market.

Additionally, the terms of CCDs can vary widely, including the conversion price, the conversion ratio, the conversion date, and the redemption date. These terms can significantly impact the value of the CCD and its liquidity in the market.

Examples of Compulsory Convertible Debentures

Let's assume Pear Inc. intends to market its mobile products and services worldwide for the first time. Investors are cautious about whether the products will sell internationally and whether the company's worldwide business plan will be profitable.

The company offers CCD to attract enough investors to fund its international expansion. After three years, the conversion will be at a 20:1 ratio. The convertible debenture's fixed interest rate is 2%, lower than the normal bond rate. The lower rate, however, is a trade-off for the right to convert the debentures into shares.

Scenario 1

After three years, the foreign growth is a success, and the corporation's stock price skyrockets from $20 to $100 per share. Convertible debenture holders can convert their debt into shares at a 20:1 conversion ratio. Investors with one debenture can convert it into $2,000 in equity (20 shares at $100 each).

Scenario 2

International expansion is a failure. Investors can keep their convertible debentures and receive 2% annual fixed interest payments until the debt matures and the corporation refunds their investment. In this case, Pear benefited from low-interest financing by issuing the convertible debenture. However, if the expansion is successful, the company's equity shares will be eroded when investors convert their debentures to stock.

Conclusion

Compulsory convertible debentures are a unique financial instrument that offers companies a source of debt financing while also allowing them to convert the debt into equity later. This instrument is seen as equity but comes with debt attributes. CCDs don’t constitute credit risk as they subsequently become equity shares upon debt conversion. Investors holding these shares become owners of the company after the conversion stage.

FAQs

Q1. Why do companies issue CCDs?

Ans. Companies may issue CCDs to raise capital for their business operations, as they provide an attractive source of debt financing that can be converted into equity shares.

Q2. What are the pros of investing in CCDs?

Ans. CCDs offer investors a steady stream of interest payments and the potential for capital appreciation through converting the debenture into equity shares. Additionally, CCDs can diversify an investor's portfolio, offering a unique combination of debt and equity features.

Q3. What are the cons of investing in CCDs?

Ans. The conversion of CCDs into equity shares is required; investors may be obliged to convert their investment into equity shares regardless of market conditions. Furthermore, the liquidity of CCDs might vary based on the issuer, the debenture terms, and market conditions.