What It Is:
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 some 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.
 
How It Works/Example:
For example, let's consider a XYZ Company bond that is exchangeable into shares of ABC Company at an exchange ratio of 50:1. This means that you could exchange every $1,000 of par value you own of XYZ bonds into 50 shares of ABC stock. This effectively means you have the option to purchase ABC Company stock for $1,000/50 = $20 per share. If ABC Company shares were trading for $50 per share, you would probably exchange the bond and then sell the shares, pocketing a profit of $30 per share ($50 received per share - $20 paid per share). But if ABC Company shares were trading for $10 per share, you would have no incentive to convert the bond and would instead simply continue to receive coupon payments.
 
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.
 
In general, holders of exchangeable bonds are entitled to antidilution adjustments from the issuer. These compensate bondholders for events such as capital distributions that benefit all of the shareholders in the underlying company (ABC Company in our example). Further, in the case of default, some exchangeable bonds offer holders the greater of par value or the market price of the underlying shares. This lets holders benefit from the good performance of the underlying company even if the issuer has gone bankrupt.
 
Why It Matters:
Clearly, one opportunity (or one risk) of investing in exchangeable bonds is that the investor is exposed to an underlying stock that may have an entirely different risk and return profile from the issuer. Thus, investors have the option to invest in an entirely different company if they want to. In this sense, exchangeable bonds come with a built-in diversification option.
 
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 a little inflation protection, which is especially attractive to income investors and especially 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. Recall that 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. 
 

Income Security of the Month If you're looking for high yields, monthly payments and unprecedented safety from your investments, then you need to learn more about our "Income Security of the Month" for November 2008. This stable preferred stock has a long track record of paying some of the most solid dividends in Wall Street history. In fact, the preferred issue pays a monthly dividend totaling 10.3% annually and has outperformed the S&P 500 by more than +44 percentage points over the last year!

Top 10 Stocks for 2008! Since we began publishing this report back in 2003, the picks we've featured have consistently beaten the broader market -- delivering average gains of +21.3% per year and outperforming the S&P by a nearly 2-to-1 margin. Act now to reserve your copy of our newest report -- Top Ten Stocks for 2008.