Detailed Explanation:

Answer: Option 3 — Both 1 and 2

A convertible bond is a hybrid debt security that gives the bondholder the right to convert the bond into a predetermined number of equity shares of the issuing company. Because of this valuable conversion feature, convertible bonds typically offer lower coupon rates compared to regular bonds, making them attractive to issuers seeking to reduce interest expenses. Additionally, the conversion option provides bondholders with protection against inflation, as equity prices tend to rise with inflation, offering a degree of indexation to consumer prices.

✅ Statement 1 – Correct: Convertible bonds pay a lower rate of interest because investors are willing to accept reduced coupon payments in exchange for the valuable option to convert the bond into equity shares, which can potentially appreciate significantly.

✅ Statement 2 – Correct: The conversion option acts as an inflation hedge because equity prices generally rise with inflation, providing bondholders with indexation to rising consumer prices that fixed-interest bonds cannot offer.

📝 Short Notes: Convertible Bonds

• Definition: Hybrid securities combining features of debt (fixed interest) and equity (conversion option).
• Lower Coupon Rate: Investors accept 1-2% lower interest compared to regular bonds due to the conversion feature.
• Conversion Ratio: Predetermined number of shares the bondholder receives upon conversion.
• Benefits to Issuer: Lower interest costs and delayed equity dilution until conversion.
• Benefits to Investor: Fixed income with upside potential if company's stock price appreciates; inflation protection through equity exposure.
• Conversion Price: Usually set at a premium (15-30%) above the stock price at issuance.
• Types: Vanilla convertibles (bondholder's option), mandatory convertibles (automatic conversion), and reverse convertibles.