What it means
A debenture is a written acknowledgement of debt. In North American usage it means unsecured corporate debt, while in the United Kingdom the same word is often used for a document that does grant security over assets, so the first thing to check is which meaning applies.
Adding a conversion right turns the debenture into a hybrid. The holder collects interest like any lender but can walk away from that position and become a shareholder if the share price rises above the conversion price.
Because the conversion right has value, issuers can pay a noticeably lower coupon than they would on straight unsecured debt. That saving is the main attraction for a growing company that wants to preserve cash while it builds out capacity or funds an acquisition.
Ranking matters a great deal with these instruments. An unsecured convertible debenture ranks behind secured lenders in a wind-up, so the holder is accepting more credit risk than a mortgage bondholder, and the conversion right is part of the compensation for that.
The main cost to existing shareholders is dilution. Every debenture that converts creates new shares, and boards should model the fully converted share count before issuing rather than discovering the effect years later when the shares are performing well.
In practice
Real-world examples.
Example
A regional food producer raises $8,000,000 through convertible debentures at 4% rather than a bank term loan at 8%. The lower coupon frees up cash for a new production line, and the lenders accept it because a rising share price would let them convert.
Example
A property services group issues convertible debentures to fund an acquisition while its bank facilities are already fully drawn against secured assets. The debenture holders rank behind the bank but take a conversion right as compensation for the weaker position.
Example
An investor comparing two offers from the same issuer picks the convertible debenture at 4% over the secured bond at 6%. She accepts two percentage points less income and a lower ranking in return for a right to convert at a 30% premium to today's share price.
Formula
Calculation
Number of debentures = Total issue size / Face value per debenture. Shares created on full conversion = Number of debentures x (Face value / Conversion price). Dilution % = New shares / (Existing shares + New shares).
A speciality manufacturer issues $5,000,000 of convertible debentures with a face value of $1,000 each and a 5% coupon, so there are $5,000,000 / $1,000 = 5,000 debentures paying 0.05 x $5,000,000 = $250,000 of interest a year. The conversion price is set at $20 per share.
Shares per debenture = $1,000 / $20 = 50 shares. Shares created on full conversion = 5,000 x 50 = 250,000 shares.
The company already has 2,000,000 shares in issue, so full conversion takes the total to 2,000,000 + 250,000 = 2,250,000 shares. Dilution = 250,000 / 2,250,000 = 11.1% of the enlarged company. In exchange, the business removes $5,000,000 of debt and stops paying $250,000 a year in interest, so the board is trading $250,000 of annual cash cost against giving up 11.1% of the ownership.Case study
Seen in the real world.
This is an illustrative case involving a fictional company. Kestrel Fabrication Group, an invented metal components manufacturer, raised $5,000,000 through convertible debentures at 5% with a conversion price of $20, against a share price of $14 at the time of issue. The board focused on the interest saving compared with the 9% its bank was quoting and gave little thought to what happened if the plan worked.
Three years later a large defence contract lifted Kestrel's share price to $34, and holders converted in full. The company cleared $5,000,000 of debt and saved $250,000 a year in interest, but the founding family's combined stake fell from 52% to just under 47%, and it lost outright control of the general meeting.
Kestrel's board had never modelled the fully diluted ownership table at different share prices. In this fictional example the financing was sound and the outcome was good for the business, but the control consequence was a surprise that a single spreadsheet would have avoided.
Watch out
Common mistakes.
- Assuming a debenture is always secured. In North American usage a debenture is unsecured corporate debt, so holders rank behind secured lenders, and the wording of the specific instrument is what settles the question.
- Judging a convertible debenture purely on its coupon. The low interest rate exists because the holder has been given a conversion right, so the real cost includes the shares that may be created later.
- Leaving the fully converted share count out of the board pack. Dilution is easy to model in advance and awkward to explain after the fact, particularly where control of the company is finely balanced.
Questions
People also ask.
How does a convertible debenture differ from a convertible bond?
The mechanics are the same, and the difference is mainly one of terminology and security; a debenture typically denotes unsecured debt in North American usage.
Do holders have to convert?
No, conversion is a right rather than an obligation, so a holder who prefers the income can simply keep collecting interest and be repaid at maturity.
What happens to a convertible debenture if the company goes into insolvency?
It ranks as unsecured debt, behind secured lenders but ahead of ordinary shareholders, and the conversion right becomes worthless once the equity has no value.
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