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| Exchangeable
Bonds |
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.
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