Exchangeable bond

An exchangeable bond provides security together with elasticity in the bond markets; thus, it generates fixed income while offering the growth opportunities of equities. This exchangeable bond is unique in its characteristics since it is allowed to convert a bond into the shares of a company other than the issuer, which actually differentiates it from the rest of the bond family. It shows potential excitement for investors. 

What are exchangeable bonds, How do they work, and why are they important in the larger investment context? We will also look at some of the types of exchangeable bonds. 

What is an Exchangeable Bond? 

An exchangeable bond is a form of debt security issued by a firm that allows the holder of an exchangeable bond to take the obligation matured in a different firm’s shares rather than shares of the issuing company itself. Again, in the traditional way of bonds, exchangeable bonds pay periodic interest to investors, known as coupons, and the bond’s principal amount matures at the time if not exchanged for shares. 

The exchangeable bond attracts investors because it combines the security associated with bond investment with the possibility of capital gains when the market price of the underlying share is more than the issue price. Such exchangeable bonds are issued by companies holding large shares in another company. These types of bonds help such companies to raise funds without selling the equity directly. 

An example could be a US company issuing exchangeable bonds tied to shares of a great technology company like Apple. Investors holding those bonds can exchange them with shares of Apple at a pre-specified conversion rate. 

Understanding Exchangeable Bonds 

The basic attractiveness of a convertible bond lies in the fact that it serves a holder in two capacities: fixed income as interest payments when accrued and the option for capital gains through a conversion option. When the holder decides to convert their bond into shares, they can sell the shares at a profit because the underlying stock’s price has risen. On the contrary, if the stock price is on the decline or flat, the bondholder may hold on to the bond and have interest payments up to maturity to keep a fallback position in times of volatility.

Normally, exchangeable bonds are issued by companies that desire to realise their holdings in other firms in a money form, but selling shares is not a desired act. Such an issuance lets the issuing firm raise funds without the relinquishment of the control of those shares for any definite term. For an investor, exchangeable bonds offer the possibility of investing in the potential growth prospects for the shares issued by a firm while retaining the security of a bond on board. 

These exchangeable bonds are issued under pre-set terms, including the ratio of exchange that the bondholder will receive in exchange for a bond, the time period for the exchange, and the conversion price at which the bond can be exchanged for shares. 

Types of Exchangeable Bonds 

There are two types of exchangeable bonds, and these are must-knows for every investor: mandatory exchangeable bonds and optional exchangeable bonds. 

• Convertible Bonds with compulsory conversion: In these bonds, the bondholder has to exchange the bond for shares by a date, usually that of maturity. At maturity, the investor cannot receive the cash but will have to exchange the bond for the agreed-upon number of shares. This is generally set as a fixed ratio; hence, the investor knows how many shares he will receive when the bonds are issued. 

• Optional Exchangeable Bonds: In the case of optional bonds, the bondholder is free to exercise his choice or not to exchange the bond into shares. If the share price of the underlying company strongly increases over the bond’s life, it leaves much to be desired if the investor decides to exchange the bond and takes advantage of the increase in share price. If the share price does not unfold like in the projections, investors can wait until maturity; meanwhile, they will get their interest payment on the bond. 

The type of exchangeable bonds has different levels of control and risk for investors. Optionally exchangeable bonds are more flexible and offer greater choices regarding the timing of conversion. 

Mechanics of Exchangeable Bonds 

The mechanics of exchangeable bonds are pretty straightforward but are worthy of some depth in explanation. Any bond purchased by an investor generates regular interest payments. Interestingly, these bonds enable the holder to exchange the bond for a defined number of shares of a chosen company through the exchange ratio. 

The exchange ratio determines the number of shares that the bondholder will be entitled to for one bond. It is determined and set at the time the bond is issued and remains fixed throughout its life. A specific time of opportunity exists for the bondholder to exchange the bond into shares. This period of exchange might be from the date of issuance of the bond up to its maturity, or it could be specified as a finite time during the fixed life of a bond. 

If the bondholder exercises an option to swap the bond for shares, he will not receive any more interest. Still, if the shareholders somehow manage to sell at an appreciation in the stock price, it may yield them a good return. If the stock price goes flat or even declines, the holder may elect not to swap the bond and will have to continue with the interest received till maturity, when he/she gets back the principal amount. 

An example could be a US company offering exchangeable bonds that can be converted into its holdings in Microsoft. Here, the exchange ratio has been quoted as ten shares of Microsoft stock for each bond. In this scenario, if the price of the company’s stock increased, then the bond holder would be able to bring his or her bond and exchange it for ten shares, hopefully with an increase in price. 

Thus, a large company that owns shares in a high-growth tech company will issue exchangeable bonds linked to that company’s stock. The corporation raises capital and retains control of its shares for a specified period. In return, investors will get a fixed income and a potential upside in the stock price. 

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