Certified Anti-Money Laundering Specialist Certification (CAMS) Practice Exam

Why do convertible bonds generally have lower interest rates compared to non-convertible bonds?

1. They are issued by companies with poor credit ratings.

2. They provide no value when the stock price decreases.

3. They can increase in value as the underlying stock price rises.

4. They are more complex financial instruments.

The correct answer is: They can increase in value as the underlying stock price rises.

The correct answer highlights that convertible bonds typically have lower interest rates compared to non-convertible bonds because they include a conversion feature that allows bondholders to convert their bonds into a predetermined number of shares of the company's stock. This feature presents an added value for investors, especially in a bullish market where stock prices are expected to rise. As the underlying stock price increases, the potential for bondholders to convert their bonds into equity becomes more attractive, providing the opportunity for capital appreciation beyond the bond’s fixed interest payments. Consequently, investors are willing to accept lower interest rates on convertible bonds because the conversion feature compensates for the reduced yield, aligning with their investment strategy of benefiting from equity price appreciation. This makes convertible bonds inherently less risky compared to non-convertible bonds, which do not offer the same potential for additional returns through equity conversion. The other factors mentioned in the alternatives may address characteristics of different types of bonds, but do not relate directly to the fundamental reason behind the interest rate differences between convertible and non-convertible bonds. For instance, poor credit ratings would typically lead to higher interest rates to compensate for risk, and the complexity of the instruments may not necessarily influence the interest rate in the same way that the conversion privilege does.