Q. With reference to Convertible Bonds, consider the following statements:
1. As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
2. The option to convert to equity affords the bondholder a degree of indexation to rising consumer prices.
Which of the statements given above is/are correct?
a) 1 only
b) 2 only
c) Both 1 and 2
d) Neither 1 nor 2
Correct Answer: c) Both 1 and 2
Question from UPSC Prelims 2022 GS Paper
Explanation :
Understanding Convertible Bonds and Inflation Hedging
Interest Rates on Convertible Bonds
Convertible bonds are a unique financial instrument that combines elements of both debt and equity. They offer investors a fixed income through interest payments, but also include an option to convert the bond into a set number of shares of the company’s stock. The presence of this conversion feature means that investors are typically willing to accept a lower interest rate than they would for a comparable non-convertible bond, as the conversion option adds potential value through the opportunity for capital appreciation.
Inflation Hedging with Convertible Bonds
Convertible bonds do not directly index to inflation like some other securities, but they do offer an indirect form of protection against rising consumer prices. This is because the conversion feature allows bondholders to benefit from the issuing company’s stock price increases, which may be partly due to the company’s ability to pass on inflationary costs to consumers. As a result, the bondholder can potentially enjoy equity growth that correlates with rising consumer prices, providing a measure of inflation hedging. This can be especially valuable in a growing economy, where the return on equity may outpace inflation, unlike fixed income returns.
