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 ✓ UPSC's answer
- (d) Neither 1 nor 2
Why the answer is (c)
• A convertible bond is a debt instrument that the holder may exchange for a fixed number of the issuer's shares.
• Statement 1 is correct: because the conversion option has value — the holder can share in equity gains — investors accept a lower coupon than on a plain bond.
• Statement 2 is correct: since share prices tend to rise with inflation over time, the option to convert gives the bondholder some protection against rising consumer prices, unlike a fixed-coupon bond.
• Companies issue convertibles to raise cheaper debt; India's Foreign Currency Convertible Bonds are an example.
• Hence both 1 and 2, option (c).
Why the other options are wrong
- (a) 1 only
- Statement 2 is also correct: equity conversion offers inflation protection.
- (b) 2 only
- Statement 1 is also correct: convertibles carry lower coupons.
- (d) Neither 1 nor 2
- Both statements are correct.
Asked in the GS Paper I of the UPSC Civil Services Preliminary Examination 2022, held on 5 June 2022. Question and answer key: Union Public Service Commission. Explanation: UPSC Answer Check.