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

Ananya Ltd has a 10-year convertible bond with a 6% coupon on ₹1,000 face value. Similar non-convertible bonds of the same risk yield 9%. Why is the coupon on the convertible acceptable to investors?

Investors accept the lower 6% coupon because a convertible bond includes an embedded option to convert into shares, which has positive value and compensates for the lower yield compared with a 9% straight bond.

  1. ABecause the conversion option has value, compensating investors for the lower couponCorrect
  2. BBecause convertibles always rank below preference shares in liquidation
  3. CBecause convertible holders are exempt from tax on the coupon
  4. DBecause the conversion option reduces the bond's credit risk to zero
  5. Because the coupon is guaranteed to rise when shares are converted

Explanation

A convertible equals a straight bond plus a call option on shares. Investors accept a lower coupon because the embedded option has positive value. The other options state false features of convertibles.

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