A convertible debenture is a bond that may be exchanged for stock at a particular point in time by the investor or the issuing company. The option to convert to stock is an enticement for investors to take positions in this security. Because of the conversion option, convertible debentures may pay a lower interest rate than traditional bonds because of the potential gains from converting to stock. The proceeds from a convertible debenture are used by the issuing company for a particular project or expand operations. However, despite their potential for returns, convertible debentures carry disadvantages worth considering.
Convertible debentures may remain vulnerable to the issuing company’s credit rating. Generally, companies with strong credit ratings are more likely to repay convertible debenture investors. However, if a strong credit rating is downgraded by rating agencies, the risk of default may increase making the convertible debenture a more risky investment. Similarly, investing in convertible debentures from companies with less favorable credit ratings increases the risk of default.
In addition, if the company issuing convertible debentures falls into bankruptcy, you may not necessarily recover your investment. If you hold a convertible debenture, you are considered a creditor of the company. Creditors are commonly paid before shareholders out of the remaining assets of the bankrupt company. However, this may not always be the case.
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Convertible debentures are unsecured bonds, backed only by the issuing company’s credit rating and long-term profitability. If the company runs into financial trouble, investors in convertible debentures may only be able to claim company assets that are not already used to back other bond issues or collateral for additional credit lines. In addition, like most securities, bonds are not insured against loss by the federal government or any other agency.
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