An exchangeable bond authorizes the holder the option to replace the bond for the stock of a company other than the issuer (usually a subsidiary) at a predetermined future date and under prescribed conditions.
This is different from a convertible bond in a way that it gives the holder the option to exchange the bond with other securities (usually stock) that are offered by the issuer.
It is a type of convertible bond where the investor has the right to convert the bonds into equity shares of other companies instead of the issuing company of the bond. Mostly the option is exercised to buy the shares of subsidiaries of the issuing company.
However, there are certain conditions that are needed to be fulfilled in order to convert this bond. One of the conditions includes that there is a specific time limit for the conversion of these bonds.
For instance, let’s consider a company ABC bond that is exchangeable into shares of company XYZ at an exchange ratio of 50:1 which means that one can exchange every $1,000 of the par value of ABC bonds into 50 shares of XYZ stock.
This means that a person has the option to buy Company XYZ stock for $20 per share ($1,000/50). If XYZ shares were trading for $50 per share, one would probably replace the bond and then sell the shares, by this way one can earn a profit of $30 per share ($50 received per share – $20 paid per share).
But if the share of XYZ were trading for $10 per share, one would have no incentive to convert the bond and would simply continue to receive coupon payments instead.
Like convertible-bond holders, exchangeable-bond holders also accept lower coupon rates because there is a chance they have to profit from the underlying stock’s increase.
In similar manner issuers often give up equity in return for these lower interest rates. The maturity time for these exchangeable bonds is usually from three to six years.
Kinds of exchangeable bonds
Apart from normal exchangeable convertible bonds, there are two other kinds of exchangeable bonds which are discussed as under;
Foreign Currency Exchangeable Bonds
The interest amount and the principal amount is payable in foreign currency under this type of bond. The offered company whose equity shares can be bought by the bondholder while exercising the right of conversion must receive foreign investments.
Mandatory Exchangeable Bonds
These bonds have to be converted in to equity shares either at the predetermined date for conversion or before. Here the bondholder is tied to use his right for the conversion of the bond into equity shares.
Importance of Exchangeable Bonds
- The investment portfolio becomes diversified with the help of these exchangeable bonds. One of the main risks associated with investing in exchangeable bonds is that the investor is exposed to an underlying stock that may have altogether different risk and return profiles from the issuer. In this way, investors have the option to invest in a completely different company if they have the option and also want to. So it can be said that exchangeable bonds come with a built-in diversification option.
- These bonds provide a complete set of variable risks and returns from the issuing company to the investors.
- Another benefit of these bonds is that they provide a kind of inflation protection. A bond is yielded like a bond when the share price of the underlying asset is below the exchange price, while it acts like stocks when the share price is above the exchange price. In simple words, investors consider exchangeable bonds as stock investments with coupons attached. This due to the reason that exchangeable bonds trade like bonds when the share price is far below the exchange price however trade like stocks when the share price is above the exchange price. This type of relationship with stock prices means exchangeable bonds provide a little inflation protection, which seems attractive to income investors.
- Issuing the exchangeable bonds means selling a large portion of their holdings to another company. The major drawback of selling the shares directly to the other company is that the issuing company is diluting the shareholding of its own shareholders. It has a major impact on the market reputation of the company. However, adopting this method of issuing exchangeable bonds will save these issues from arising. Since exchangeable bonds turn into shares of another company hence no such dilution occurs.
All in all, exchangeable bonds prove to be profitable both from the company as well as the investor’s point of view. The right remains with the investors to take part in the share price appreciation of the offered company and also they possess the option of increasing their return on investment without diluting the shareholding of the issuing company.