What is an Exchangeable Bond and How Does It Work?

An exchangeable debt or bond can be converted into equity of a company other than the issuer of the debt. The investors keep the option of converting the bond into equity but not the legal obligation.

An exchangeable bond offers embedded diversification of risk for the investors. At the same time, investors face a higher risk that comes through the stock performance of another company. The value of an exchangeable bond is always higher than a straight bond as it comes with a call option for conversion.

What is an Exchangeable Bond?

An exchangeable bond can be converted into stocks of a company other than the bond issuer. This company is usually a subsidiary of the company issuing bonds. The exchange feature works similarly to a convertible bond.

The investors of an exchangeable bond are exposed to different kinds of risks. One with the interest rate and hence the performance of the bond itself. Another with the performance of the company that comes with an exchange offer. At the same time, investment in an exchangeable bond offers a diversification of risk as it involves another company for the stock exchange.

How Does an Exchangeable Bond Work?

An exchangeable bond can be viewed as a straight bond plus an embedded option for exchange with equity. The bond pricing, maturity, coupon rate, and other terms are agreed upon in a similar way to a straight bond. Additionally, the issuer offers an embedded option of stock exchange at a specified date and price.

It can offer stock conversion at different rates. For instance, a bond issuer can offer a stock exchange with a 50:1 ratio. It means for the par value of a bond $1,000; you can exchange 50 stocks of the company.

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In other words, you can own the stocks of the company at $ 20 per share with a 50:1 exchange offer. Investors would make an exchange if the stock price rises above $ 20 and would let the option lapse if the price falls below $20.

Example

Suppose a company wants to raise capital through an exchangeable bond. It offers an exchangeable bond at a par value of $ 1,000. The embedded option of exchange is 50:1 for its subsidiary. The subsidiary’s stock is currently trading at $ 30.

If at the time of exchange, the stock price goes above $30, say to $ 40. The investor would sell the bond and exchange it with stocks of the subsidiary company earning a profit of $ 10 per share. Contrarily, if the share price of the subsidiary falls below $30, the investors wouldn’t exercise the exchange option as it will incur losses.

Special Considerations with an Exchangeable Bond – Difference from Convertible Bond

An exchangeable bond and a convertible bond work similarly. Both types of bonds give the bondholders an option to exchange debt with equity. Both come with an option of conversion but not an obligation. However, the key difference between the two is the stocks converted through a convertible bond are owned by the bond issuer itself.

On the other hand, it offers a stock exchange with stocks owned by another company. This company is usually the subsidiary company of the bond issuer.

Bond issuers can enjoy several advantages with an exchangeable bond. For instance, it does not dilute the company’s share position as no new shares are issued by the bond issuer. It can also be used for a sell-off position in other companies.

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Advantages of an Exchangeable Bond

An Exchangeable bond offers several advantages to the bond issuers and bondholders.

  • It offers investment diversification for investors.
  • Bond issuers can raise capital with lower interest rates as compared to a straight bond.
  • The bondholders can convert debt with equity for another company and make substantial profits.
  • Bond issuers can use it for sell-offs and divestments in other companies such as subsidiaries of a group.
  • Investors can feel protection against inflation as they have an investment in a bond and stocks at the same time.

Disadvantages of an Exchangeable Bond

An Exchangeable bond offers some disadvantages to both parties as well.

  • Stock conversion is an option that may not attract large investments as required by the bond issuers.
  • It dilutes the stocks in issue for the secondary company if the option is exercised.
  • Investors receive lower coupon payments and would need to exercise the conversion clause to make profits.
  • It also depends on the performance of the other company, if stocks of that company are trading low, the exchange option becomes worthless for the bondholders.

Conclusion

An exchangeable bond allows the bondholders to convert debt into equity. A key feature of exchangeable debt is that it offers stocks of a company other than the bond issuer. It can protect investors with diversification and inflation risks with investment in bonds and stocks at the same time. However, the option is equally risky as both companies may not perform well as anticipated by the investors.

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