UPSC Prelims 2022 Q65: Convertible Bonds — Interest and Inflation
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?
- 1 only
- 2 only
- Both 1 and 2
- Neither 1 nor 2
Answer: (c) Both 1 and 2
Statement-wise explanation
- 1: correct — A convertible bond comes with an embedded call option: the holder can exchange it for a fixed number of the issuer's shares. Investors pay for that option by accepting a lower coupon than a comparable plain (non-convertible) bond from the same issuer. That is why companies use convertibles to borrow more cheaply, and the lower rate follows directly from the conversion option.
- 2: correct — A plain bond pays fixed nominal sums, so rising consumer prices eat into its real value. Equity is a claim on a firm's assets and earnings, and these tend to rise in nominal terms as the price level rises. The option to convert therefore lets the holder share in that rise. This is only partial protection, which is why the statement says 'a degree of'. It is not formal indexation, as in an Inflation Indexed Bond whose principal is tied to a price index.
How to eliminate
Statement 1 is close to a definition. Any option given to an investor has a price, and with convertibles the investor pays it through a lower coupon. If you know that a convertible is 'bond plus option', you can mark Statement 1 correct and keep only 'Statement 1 only' and 'both'. Statement 2 is the deciding one. Look at its wording: 'affords… a degree of indexation' is a cautious claim, not an absolute one. It does not say the bond is inflation-indexed. It only says the equity link gives some protection against rising prices. Basic reasoning supports this: a fixed-coupon bond loses real value in inflation, while shares are a claim on real assets and nominal profits. Hedged phrases like 'a degree of', 'may' and 'generally' are usually true in UPSC economy statements. The fact to remember: bonds are hurt by inflation, equity is a partial hedge, so a bond with an equity option gets some of that hedge.
Know more
Convertible bond = straight bond + call option on the issuer's shares.
The holder receives coupons and principal like any bondholder. They may also swap the bond for a fixed number of shares (the conversion ratio). The conversion price is the face value divided by the conversion ratio. Example: a ₹1,000 bond convertible into 50 shares is worth converting only when the share trades above ₹20.
Why the issuer likes it: a lower coupon than ordinary debt, and dilution of existing shareholders is postponed until conversion. Why the investor accepts it: upside if the share price rises, a bond floor if it falls, and priority over shareholders in insolvency.
SEBI defines a convertible bond as one "giving the investor the option to convert the bond into equity at a fixed conversion price".
| Instrument | Coupon | Inflation protection | Key feature |
|---|---|---|---|
| Plain fixed-rate bond | Fixed | None | Real value falls when prices rise |
| Convertible bond | Lower than plain bond | Partial, through the equity option | Can be swapped for shares |
| Floating rate bond | Reset to a benchmark | Indirect, if rates follow inflation | Coupon moves with market rates |
| Inflation Indexed Bond | Fixed real rate | Direct: principal linked to a price index | Explicit indexation |
| FCCB | Usually low | Partial | Convertible bond issued abroad in foreign currency |
| Zero-coupon bond | None | None | Issued at a discount |
Variants to know:
- Optionally convertible: the holder decides whether to convert.
- Compulsorily/mandatorily convertible: conversion is required.
- Contingent convertibles (CoCos), such as bank AT1 bonds: conversion or write-down is triggered by the issuer's capital falling below a set level, not by the investor's choice. The trigger works against the investor, so these pay higher coupons.
NCERT Concepts to Revise
- Convertible bond: Both statements depend on the bond's defining feature: the holder's right to exchange it for a fixed number of shares.
- Foreign Currency Convertible Bond: FCCBs are the convertible type Indian companies most often issue, so they are a likely follow-up in UPSC questions.
- Floating rate bond: A floating coupon is another way bonds handle rising prices, useful to compare when judging Statement 2's claim.
- Bond price and interest rate inverse relation: Explains why fixed-income instruments lose value as rates and inflation rise, which is the background to Statement 2.
- AT1 bonds: AT1 bonds are contingent convertibles; they show how the conversion option can favour the issuer instead of the investor.