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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Warrant Coverage

What it is:

Warrant coverage is an agreement to provide warrants to a shareholder.

How it works (Example):

Warrants are securities that give the holder the right, but not the obligation, to buy a certain number of securities (usually the issuer's common stock) at a certain price before a certain time. Warrants are not the same as call options or stock purchase rights.

Occasionally, companies offer warrants for direct sale or give them to employees as incentive, but the vast majority of warrants are "attached" to newly issued bonds or preferred stock.

For example, if Company XYZ issued $100 million of bonds with 30% warrant coverage, each bondholder might get a $1,000 face-value bond and the right to purchase 15 shares of Company XYZ stock at $20 per share (for a total of $300, or 30% of the $1,000 face value). Warrants usually permit the holder to purchase common stock of the issuer, but sometimes they allow the purchaser to buy the stock or bonds of another entity (such as a subsidiary or even a third party).

The price at which a warrant holder can purchase the underlying securities is called the exercise price or strike price. The exercise price is usually higher than the market price of the stock at the time of the warrant's issuance. In our example, the exercise price is $20, which is probably 15% higher than what Company XYZ stock was trading at when the bonds were issued. The warrant's exercise price often rises according to a schedule as the bond matures. This schedule is set forth in the bond indenture.

One important characteristic of warrants is that they are often detachable. That is, if an investor holds a bond with attached warrants, he or she can sell the warrants and keep the bond. Warrants are traded on the major exchanges. In some cases where warrants have been issued with preferred stock, stockholders may not receive a dividend as long as they hold the warrant. Thus it is sometimes advantageous to detach and sell a warrant as soon as possible if the investor expects to earn more from dividends.

Why it Matters:

Warrant coverage allows the holder to participate in the price appreciation of the underlying security (Company XYZ common stock in our example). This is because the higher the minimum value of the warrant, the more the bond or preferred itself trades like the underlying security. For example, the price of a Company XYZ bond with a warrant attached tends to rise as the price of Company XYZ common stock approaches the exercise price (similar to a call option).

This opportunity to participate in the upside of another security give investors a little diversification and thus is a way to mitigate risk. As a result, companies often issue bonds and preferred stock with warrant coverage as a way to enhance the demand and marketability of the offering. This in turn lowers the cost of capital for the issuer.

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