Difference Between Convertible And Non-Convertible Debentures: Meaning, Features & Comparison

Some investments continue the same way from beginning to end. Others can change along the way. Convertible and non-convertible debentures are a good example for these. Both of them begin as debt instruments. However, one of them can be converted into equity shares. The other remains a debenture until maturity. This also affects their returns, risk and investment objectives.

This article explains both types of debentures and the key differences between them.

What Are Convertible Debentures?

A convertible debenture is a loan you give a company that comes with an option: at a later date, you can convert it into shares of that company instead of getting your money back.

Until that conversion happens, it works like any other debt investment; the company pays you interest, and your capital is at less risk than equity since debenture holders get repaid before shareholders if the company runs into trouble. But if the company's stock does well, you have the choice to convert your debenture into shares and participate in that upside instead of just collecting interest.

In short: you start as a lender, with the option to become a shareholder later, giving you the safety of debt with the potential of equity, depending on which way the company goes.

What Are Non-Convertible Debentures (NCDs)?

A non-convertible debenture is much simpler. You invest money, and the company pays you interest. This continues for the entire duration of the investment. Once the tenure comes to an end, the company returns the amount you invested. The investment does not change into equity shares at any stage. Hence, you remain a lender throughout the investment tenure.

The absence of a conversion option is one reason why NCDs often carry a higher rate of interest.

Difference Between Convertible And Non-Convertible Debentures

Convertible and non-convertible debentures start out looking the same, both are loans to a company that pay interest. The difference is what happens at maturity: one gives you the option to convert into shares, the other simply returns your capital.

How Do Convertible And Non-Convertible Debentures Work?

The process starts even before the debentures are offered to investors. The company first decides the type of debenture it wants to issue. If it chooses convertible debentures, the conversion terms are decided at this stage itself. If it issues NCDs, investors know from the beginning that there is no conversion option.

1. Everything begins at the time of issuing. Before inviting investors, the company decides whether it will issue convertible debentures or NCDs.

2. The company shares all the important terms. These include the interest rate and tenure. If the debentures are convertible, the conversion terms are also announced.

3. You decide whether to invest. Once you subscribe, the company starts paying interest according to the issue terms.

4. This is where the two begin to differ. A convertible debenture can become an equity share later. An NCD does not. It remains a debt investment.

5. Once the investment is completed, you become a shareholder after conversion, in the case of a convertible debenture. An NCD, on the other hand, pays back your principal amount on maturity.

Why Do Companies Issue Convertible And Non-Convertible Debentures?

A company does not choose the same type of debenture every time it needs funds. The decision depends on how it plans to raise money and what it is willing to offer investors in return. In some situations, a convertible debenture makes more sense. In others, an NCD may be the better choice.

Convertible debentures are issued for the following reasons:

• A lower interest cost is often one of the biggest reasons.

• Some companies want to delay the dilution of ownership. Convertible debentures make that possible.

• The conversion option can attract more investors. This may improve the response to the issue.

• Companies may want to issue shares, but not at the current market price. Convertible debentures give them additional time.

Non-convertible debentures are issued for the following reasons:

• Ownership remains unchanged because there is no conversion into equity.

• Companies that only want to borrow money often prefer this route.

• Regular income appeals to many investors. This makes NCDs attractive to a different set of investors.

• May suit companies with predictable cash flows. Planning regular interest payments becomes easier.

Common Mistakes To Avoid Before Investing

Convertible and non-convertible debentures are designed for different investment objectives. A feature that works well for one investor may not suit another. Looking beyond the interest rate or the conversion option can help you make a more informed choice.

Listed below are common mistakes you should watch out for:

• A higher interest rate can be tempting. NCDs often offer better interest than convertible debentures. That alone should not decide your investment.

• The conversion terms deserve a closer look. The conversion date, ratio and price decide what you receive if you choose a convertible debenture.

• Do not overlook the credit rating. It tells you how credit rating agencies view the issuer's ability to meet its repayment obligations.

• Liquidity is easy to ignore. If there are not enough buyers in the market, you may have to wait longer or sell at a less favourable price.

• Your financial goal should come first. If regular income is your priority, an NCD may suit you better. If you are comfortable with equity exposure later, a convertible debenture could be the better fit.

• Do not compare only the returns. The risks, tenure and features of the two instruments are equally important.

Conclusion

Convertible and non-convertible debentures serve different investment needs. One offers the possibility of becoming a shareholder. Another focuses on generating a fixed income. Instead of asking which one is better, think about what you expect from your investment. Choose between the two based on your financial goals and risk appetite.