UPSC Prelims 2022 Q65: Indian Economy – Financial Markets & Capital Markets
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
Answer: (c) Both 1 and 2
Explanation
Convertible bonds
A convertible bond is a debt instrument that the holder can swap for a fixed number of equity shares.
| Statement | Verdict | Reason |
|---|---|---|
| 1. Convertibles pay lower interest because of the equity option | Correct | The conversion option has value, so investors accept a lower coupon |
| 2. The option gives some indexation to rising consumer prices | Correct | In inflation, nominal profits and share prices tend to rise, so the equity option offers a partial hedge |
Bond types compared:
| Feature | Plain bond | Convertible bond |
|---|---|---|
| Coupon | Higher | Lower |
| Upside | Fixed interest only | Gains if share price rises |
| Inflation protection | None | Partial, through equity |
Answer: (c) Both 1 and 2.
Why each option is right or wrong
- (a) Incorrect. Statement 2 is also true; the equity option gives partial protection against inflation.
- (b) Incorrect. Statement 1 is also true; convertibles pay a lower coupon because of the option.
- (c) CORRECT. The option lowers the coupon and offers some inflation hedge via rising share prices.
- (d) Incorrect. Both are standard features of convertible bonds.
Key point
Convertible bonds pay a lower coupon because the equity option has value; equity exposure gives partial inflation indexation.
Remember
Convertible = lower coupon + equity upside + partial inflation hedge.
Common mistakes
- Thinking convertibles pay higher interest because they are 'more flexible'.
- Not seeing how equity acts as a partial hedge against rising prices.
- Confusing convertible bonds with inflation-indexed bonds, which link payouts to CPI directly.
Exam tip
Any extra option for the investor is paid for with a lower yield.
Sources
- SEBI — Issue of Capital and Disclosure Requirements (convertible securities)
- Companies Act, 2013, Section 62(3) (convertible debentures and bonds)