•   A convertible bond is a type of debt instrument which provides an investor with a right or an obligation to exchange the bond for a predetermined number of shares in the issuing company at certain times of a bond’s lifetime. It is a hybrid security that possesses features of both debt and equity.

•   As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest. A convertible bond protects investors’ principal on the downside, but allows them to participate in the upside should the underlying company succeed. However, convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock. Companies benefit since they can issue debt at lower interest rates than with traditional bond offerings. Hence, statement 1 is correct.

•   The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices. As indexation will ensure that prices are adjusted with inflation over a period of time. With the help of indexation, bondholders will be able to lower their long-term capital gains (as their investment will be adjusted with inflation) even when converting bonds into equity, which brings down their taxable income. Hence statement 2 is correct.

Advantages

•   Issuing companies can save money on their interest payments.

•   Since interest payments are tax-deductible, convertible bonds allow the issuing company to benefit from interest tax savings that are not possible in equity financing.

•   If a company is not willing to dilute its stock shares in the short or medium term but is comfortable doing so in the long term, convertible bond financing is more appropriate than equity financing.