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?

The correct option is Both 1 and 2.

Explanation of Statement 1:
A convertible bond is a hybrid financial instrument that behaves like a regular debt security but includes an embedded option allowing the bondholder to convert the bond into a specified number of equity shares of the issuing company. This conversion feature is highly valuable to investors because it provides potential upside if the company's stock price increases. Because investors receive this valuable option, companies are able to issue convertible bonds at a lower coupon rate (interest rate) than comparable non-convertible bonds. Therefore, Statement 1 is correct.

Explanation of Statement 2:
Inflation or rising consumer prices typically erodes the purchasing power of fixed-interest cash flows from traditional bonds. In contrast, equity shares represent ownership in a real business, and companies can often increase the prices of their goods and services to match inflation, leading to higher corporate earnings and rising stock values. Since convertible bonds can be converted into equity shares, their price is linked to the performance of the underlying stock. This conversion option provides the bondholder with a hedge against inflation, effectively affording them a degree of indexation to rising consumer prices. Therefore, Statement 2 is correct.