Mortgagerateslocal.com – Are you looking for a way to invest in a company that offers both the security of debt and the potential of equity? If so, you might want to consider compulsory convertible debentures (CCDs). Compulsory convertible debentures are a type of bond that must be converted into shares of the issuing company at a predetermined date or ratio.
They are hybrid instruments that combine the features of debt and equity, and can offer several benefits to both the investors and the issuers. We will explain what compulsory convertible debentures are, how they work, what are their advantages and disadvantages.
Also how compulsory convertible different from other types of debentures and convertible instruments. We will discuss some of the legal and tax implications of compulsory convertible debenture.
By the end of this article, you will have a better understanding of compulsory convertible debentures and whether they are suitable for your investment goals.
What are compulsory convertible debentures?
A debenture is a medium- to long-term debt instrument issued by a company to raise funds at a fixed or variable interest rate. Unlike most bonds, debentures are not secured by any collateral or assets of the issuer. They are backed only by the general creditworthiness and reputation of the issuer. Debentures can be classified into two types: non-convertible and convertible.
- A non-convertible debenture (NCD) cannot be converted into equity shares of the issuer. It pays a regular interest to the investors and returns the principal amount at maturity. The interest rate on NCDs is usually higher than that on convertible debentures, as they do not offer any upside potential to the investors.
- A convertible debenture (CD) can be converted into equity shares of the issuer, either wholly or partly, at the option of the investor or the issuer, or according to a predetermined formula. The conversion can take place at any time during the tenure of the debenture, or at maturity. The interest rate on CDs is usually lower than that on NCDs, as they offer the possibility of capital appreciation to the investors.
A compulsory convertible debenture (CCD) is a special type of CD that must be converted into equity shares of the issuer by a specified date or ratio. The conversion ratio and date are decided by the issuer at the time of issuing the debenture.
The investor has no choice but to accept the equity shares in exchange for the debenture. The interest rate on compulsory convertible debentures is usually lower than that on CDs, as they are more favorable to the issuer.
Compulsory convertible debentures are considered as deferred equity instruments, as they are essentially debt at the time of issue, but become equity after a certain period. They are also known as quasi-equity instruments, as they have some characteristics of both debt and equity.
How do compulsory convertible debentures work?
Compulsory convertible debentures work as follows:
- The issuer issues compulsory convertible debentures to the investors at a par value, which is the face value of the debenture. The par value is usually Rs. 100 or Rs. 1,000 per debenture. The issuer also decides the coupon rate, which is the annual interest rate payable on the debenture, and the tenure, which is the duration of the debenture. The coupon rate and the tenure are usually lower than those of NCDs or CDs, as CCDs are more advantageous to the issuer.
- The issuer pays the coupon interest to the investors periodically, usually semi-annually or annually. The interest is calculated on the par value of the debenture, and is taxable in the hands of the investors as income from other sources.
- The issuer also specifies the conversion ratio and date, which are the terms and conditions for converting the compulsory convertible debentures into equity shares. The conversion ratio is the number of equity shares that the investor will receive for each debenture. The conversion date is the date on which the conversion will take place. The conversion ratio and date are fixed at the time of issuing the compulsory convertible debentures, and cannot be changed later. The conversion ratio can be expressed as a percentage or a fraction. For example, a conversion ratio of 10% means that the investor will receive 10 equity shares for every 100 debentures, and a conversion ratio of 1:10 means that the investor will receive one equity share for every 10 debentures.
- On the conversion date, the issuer converts the compulsory convertible debentures into equity shares according to the conversion ratio, and issues the shares to the investors. The investors have to surrender their debentures to the issuer, and receive the shares in return. The shares are credited to the demat account of the investors, and they become the shareholders of the issuer. The issuer also pays the accrued interest, if any, to the investors along with the shares. The conversion of compulsory convertible debentures into equity shares is not taxable in the hands of the investors, as it is considered as a capital reorganization.
What are the advantages and disadvantages of compulsory convertible debentures?
Compulsory convertible debentures have several advantages and disadvantages for both the investors and the issuers, as compared to other types of debentures and convertible instruments. Some of them are:
Advantages for the investors
- compulsory convertible debentures offer a regular income to the investors in the form of coupon interest, which is usually higher than the dividend yield on equity shares. The interest is also fixed and guaranteed, unlike the dividends, which are variable and discretionary.
- compulsory convertible debentures also offer the potential of capital appreciation to the investors, as they are converted into equity shares at a predetermined ratio and date. The investors can benefit from the increase in the share price of the issuer, and also enjoy the voting rights and other privileges of the shareholders. The conversion of CCDs into equity shares is also tax-free for the investors, as it is regarded as a capital reorganization.
- compulsory convertible debentures are less risky than equity shares, as they have a seniority over the equity shares in the event of liquidation or bankruptcy of the issuer. The investors have a prior claim on the assets and income of the issuer, and are more likely to recover their investment than the shareholders. CCDs are also less volatile than equity shares, as they are less affected by the market fluctuations and the performance of the issuer.
Disadvantages for the investors
- compulsory convertible debenturesare more risky than NCDs or CDs, as they have a lower coupon rate and a longer tenure. The investors have to lock in their funds for a longer period, and accept a lower return than the market rate. The investors also have no option to exit the investment before the conversion date, unless the CCDs are listed and traded on a stock exchange, which is rare.
- compulsory convertible debentures also expose the investors to the risk of dilution of their shareholding and earnings per share, as they are converted into equity shares at a fixed ratio and date. The investors have no control over the conversion terms, and have to accept the equity shares irrespective of the prevailing market price and the financial position of the issuer. The investors may also face the risk of losing their investment, if the issuer fails to perform well or goes bankrupt.
Advantages for the issuers
- compulsory convertible debenturesare an attractive way of raising funds for the issuers, as they have a lower cost of capital than NCDs or CDs. The issuers have to pay a lower coupon rate and a longer tenure to the investors, and also save on the tax liability, as the interest expense is deductible from the taxable income of the issuer. The issuers also do not have to repay the principal amount to the investors, as the CCDs are converted into equity shares at maturity.
- compulsory convertible debentures also help the issuers to improve their financial ratios and credit ratings, as they are treated as equity rather than debt in the balance sheet of the issuer. The issuers can reduce their debt-equity ratio and leverage ratio, and enhance their solvency and liquidity position. The issuers can also avoid the risk of default or insolvency, as they do not have to repay the CCDs in cash.
- compulsory convertible debentures also enable the issuers to raise funds from a wider range of investors, as they appeal to both the debt and equity investors. The issuers can attract the investors who are looking for a regular income as well as a capital appreciation, and also the investors who are willing to take a higher risk for a higher return. The issuers can also raise funds from the foreign investors, as CCDs are considered as equity instruments for the purpose of foreign direct investment (FDI) regulations.
Disadvantages for the issuers
- compulsory convertible debentures are more disadvantageous than equity shares for the issuers, as they have to pay a fixed interest to the investors until the conversion date, and also share the ownership and control of the company with the investors after the conversion. The issuers have to dilute their shareholding and earnings per share, and also give up some of their voting rights and decision-making power to the new shareholders. The issuers may also face the risk of hostile takeover or loss of management control, if the investors acquire a significant stake in the company through the conversion of CCDs.
- compulsory convertible debentures are also more restrictive than NCDs or CDs for the issuers, as they have to abide by the conversion terms and conditions that are decided at the time of issuing the CCDs. The issuers have no flexibility to alter the conversion ratio or date, or to redeem the CCDs in cash, according to the changing market conditions and the financial needs of the company. The issuers also have to comply with the various legal and regulatory requirements for issuing and converting the CCDs, which may be complex and cumbersome.
How are CCDs different from other types of debentures and convertible instruments?
Compulsory convertible debentures are different from other types of debentures and convertible instruments in the following ways:
- Compulsory convertible debentures are different from NCDs, as they can be converted into equity shares of the issuer, while NCDs cannot. CCDs offer the possibility of capital appreciation to the investors, while NCDs offer only a fixed return. CCDs have a lower coupon rate and a longer tenure than NCDs, as they are more favorable to the issuer. CCDs are also treated as equity rather than debt in the balance sheet of the issuer, while NCDs are treated as debt.
- Compulsory convertible debentures are different from CDs, as they must be converted into equity shares of the issuer, while CDs can be converted at the option of the investor or the issuer, or according to a predetermined formula. CCDs have a fixed conversion ratio and date, while CDs have a variable conversion ratio and date. CCDs have a lower coupon rate and a longer tenure than CDs, as they are more advantageous to the issuer. CCDs are also considered as equity instruments for the purpose of FDI regulations, while CDs are considered as debt instruments.
- Compulsory convertible debentures are different from optionally convertible debentures (OCDs), as they have no option to convert or redeem the debentures in cash, while OCDs have the option to do so. OCDs are a type of CD that can be converted into equity shares at the option of the investor or the issuer, or redeemed in cash at the option of the issuer. OCDs offer more flexibility and liquidity to the investors and the issuers, while CCDs offer more certainty and stability.
- Ccompulsory convertible debentures are different from partially convertible debentures (PCDs), as they are fully converted into equity shares of the issuer, while PCDs are partly converted and partly redeemed in cash. PCDs are a type of CD that have two parts: a convertible part and a non-convertible part. The convertible part is converted into equity shares at a predetermined ratio and date, while the non-convertible part is redeemed in cash at maturity. PCDs offer a balanced mix of debt and equity to the investors and the issuers, while CCDs offer a deferred equity.
Conclusion
Compulsory convertible debenturesare a hybrid investment option that offer both the security of debt and the potential of equity. They are a type of bond that must be converted into shares of the issuing company at a predetermined date or ratio.
They are suitable for the investors who are looking for a regular income as well as a capital appreciation, and for the issuers who are looking for a lower cost of capital and a better financial position. However, compulsory convertible debentures also have some risks and challenges, such as the risk of dilution, the lack of flexibility, and the complex legal and tax implications.
