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Convertible Debentures – An Option in Volatile Markets

February 29, 2016

Guest post by Nelson Garcia:

The year 2016 has, so far, been the definition of volatility, which for many was unexpected. For some investors, switching from equities to fixed income securities (bonds) would be prudent to ensure the safety of the principal and a fixed return. But the switch will take the investor out of the stock market, therefore missing the up side, when it comes, and the hedge against inflation. Convertible debt, convertible bonds, or convertible debentures can offer the best of both worlds.

What is a convertible debenture, bond or debt?

As the name implies, convertible instruments, or converts, give the investor the option to exchange the bond for a predetermined number of shares in the issuing company. When first issued, converts act just like regular bonds with sometimes higher coupon or interest rates.

As of the year 2000, the global convertible securities market has reached an approximate value of $470 billion. The US convertible market is composed of about $160 billion. Certainly, convertible securities are popular amongst investors.

To understand the advantages and disadvantages of investing in convertible debentures, investors need to understand the investment type at its most basic level: A convertible debenture is a loan to a company. The debenture is a written promise from the company that it will repay the loan on a specified date and that the investor will receive a certain interest payment on the loan. The interest payment is then made at regular intervals. At a specified time, the debenture can be converted into shares of the company, usually at a discount to the stocks trade value.

An example:

A recent convertible debenture new issue:
Interest Rate: 8.25% interest rate (coupon)
Maturity: March 1st, 2017
Price: $1000.00 (par)
Conversion Ratio: 50% discount to common stock market value

Investors in convertible debentures get a fixed income and the option of buying stock in an up-and-coming company. This is like having your cake, eating it, and then getting to buy another one if you don’t like the taste of your first. Investors buy convertible debentures in promising companies that they are not completely sure about. If the new venture booms, they cash in their debentures for stock. The returns for an investor in a company that is performing well can be substantial. If the company does not grow or succeed as planned, the investor still has earned interest on their investment during the debenture period and their loan would be repaid.

Additionally, since the investment is considered debt and not equity, if the company fails, the investment has greater protection from loss due to the creditor status. Convertible debentures offer safety in a bear market and allow investors to convert to equity when the stock increases in value.

Convertible debentures can be a far more attractive investment proposition as compared to fixed deposits given the liquidity, the possible capital appreciation, and the higher yield.

However, no investment is without risk, and even convertible debentures come with some risk. In general, converts offer investors the advantages of relative reliability with the option to convert to equity and realize an even greater return. They also provide the issuing company a chance to raise needed capital at a reasonable interest rate and to delay the dilution of its common stock.

Contact Nelson Garcia is the managing director of Angel Investment Partners, LLC, and can be reached at 954-399-7141 for more questions and information on the process of convertible debenture investing.