What are Exchangeable Bonds?

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 Do Exchangeable Bonds Work?

For example, let's consider a Company XYZ bond that is exchangeable into shares of Company ABC 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 Company ABC stock for $20 per share ($1,000/50). If ABC 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 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.

Why Do Exchangeable Bonds Matter?

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.