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IAI Actuarial Core Principles · Business Finance · Financial instruments issued or used by companies

A company issues a convertible bond with a fixed coupon and a right for the holder to exchange it for ordinary shares at a set price. Compared with an otherwise identical straight bond, which statement is correct?

A convertible bond normally carries a lower coupon than an equivalent straight bond. The embedded right to convert into shares has value to the holder, so investors accept less interest in exchange for that upside potential.

  1. AIt normally carries a lower coupon, because the holder also receives the conversion optionCorrect
  2. BIt normally carries a higher coupon, to compensate for the dilution risk
  3. CIt must carry the same coupon, as the credit risk is unchanged
  4. DIt carries no coupon, as the return comes entirely from conversion
  5. It is repaid only in shares, never in cash

Explanation

The conversion option has value to the holder, so investors accept a lower coupon than on a straight bond of the same issuer and term. The higher coupon option reverses the logic: the option is a benefit to the holder, not a cost needing compensation.

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