With reference to Convertible Bonds, consider the following statements:
- As there is an option to exchange the bond for equity, Convertible Bonds pay a lower rate of interest.
- 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?
[UPSC Civil Services Exam – 2022 Prelims]
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: (c)
Explanation:
- A convertible bond provides fixed-interest payments but can also be exchanged for a set number of common stock shares.
- This type of security combines elements of both bonds and stocks, making it attractive to investors.
- Compared to regular corporate bonds, convertible bonds typically have lower interest rates, resulting in significant interest savings for issuers.
- Despite the lower interest payments, investors are willing to accept convertible bonds because they offer the potential to benefit from an increase in the stock price if the conversion option is exercised. Therefore, statement 1 is correct.
- Indexation is a method used by governments to potentially mitigate the negative effects of inflation on entitlements and transfer payments. Therefore, statement 2 is also correct.
