Key Takeaways:
- An exchangeable bond gives the holder the option to exchange the bond for the shares of a company other than the issuer (usually a subsidiary) at a future date and under prescribed conditions.
- An exchangeable bond can be viewed as a straight bond plus an embedded option for exchange with equity.
What is it?
An exchangeable bond gives the holder the option to exchange the bond for the stock of a company other than the issuer (usually a subsidiary) at a future date and under prescribed conditions. This is different from a convertible bond, which gives the holder the option to exchange the bond for other securities (usually stock) offered by the issuer.
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.
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.
How does it 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.
Exchangeable-bond holders, like convertible-bond holders, usually accept lower coupon rates because they have the chance to profit from the underlying stock's increase. Likewise, issuers often give up equity in return for these lower interest rates. Exchangeable bonds typically mature in three to six years.
Why do exchangeable bonds matter?
Some investors view exchangeable bonds as stock investments with coupons attached. This is because exchangeable bonds trade like bonds when the share price is far below the exchange price but trade like stocks when the share price is above the exchange price. This correlation with stock prices means exchangeable bonds provide inflation protection, which is attractive to income investors and noteworthy given that corporate bonds largely provide little if any inflation protection.
Companies often use exchangeable bonds as a method to sell off their positions in other companies. But another major advantage of exchangeable bonds (for issuers) is that they do not dilute the issuer's shareholders. As stated earlier, investors can turn convertible bonds into shares of the same issuer, which forces the issuer to issue more shares and causes dilution. Because exchangeable bonds turn into shares of another company, no such dilution occurs.
The bottom line
Exchangeable bonds can be a valuable addition to a diversified portfolio. They offer a steady and predictable income stream and, given that they have lower credit ratings than government bonds, generally offer higher yields too. However, before investing, investors need to assess the potential risks they may be exposed to.
P:S - We have used the terms Exchangeable Notes and Exchangeable bonds interchangeably for the purposes of this blog!
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