Hybrid Securities – What are Exchangeable Bonds?

What are exchangeable bonds?

Exchangeable bonds are corporate bonds with a call option on the shares of a company other than the bond issuer. Such an issue can occur when a company has built up a considerable position in another company’s shares (e.g. after an attempted take-over).

This means that instead of receiving a fixed income payment, the holder of an exchangeable bond can choose to exchange their bond for stock in a different company, typically one with a higher perceived value. This gives the bondholder the potential for greater returns, but also exposes them to the stock price fluctuations of the company they are exchanging into. In simpler terms, exchangeable bonds are like convertible bonds, but the conversion option is for stock in a different company rather than the issuer.

An example of exchangeable bonds would be a company that issues bonds that can be exchanged for stock in another, more established company. Suppose a startup technology company wants to raise capital by issuing bonds, but is not yet established enough to have a high credit rating or a stable financial track record. The startup decides to issue exchangeable bonds that can be converted into shares of a large technology company that is publicly traded and has a good reputation in the market. Investors who purchase the exchangeable bonds receive a fixed income, but also have the option to exchange their bond for shares of the established technology company if they believe that the share price of that company will increase. This offers investors the potential for higher returns, but also exposes them to the incumbent company’s stock price fluctuations.

How do Exchangeable Bonds reflect in financial statements?

Exchangeable bonds are reflected in financial statements as either debt or equity, depending on how they are accounted for.

In general, exchangeable bonds are accounted for as debt instruments and recorded on the issuer’s balance sheet as a liability. The bond’s face value and any unamortized premium or discount are reported as the liability’s carrying value, and the interest payments on the bond are reported as interest expense in the income statement.

However, in some cases, exchangeable bonds may be accounted for as equity instruments and recorded as a separate component of equity on the balance sheet. In this case, the interest payments are not recorded as an expense, but instead reduce the value of the equity component. The carrying value of the equity component would be the market value of the bond, which could be higher or lower than its face value.

Regardless of how exchangeable bonds are accounted for, the financial statements will reflect the fact that the bond is exchangeable into equity of the underlying company, and may include disclosure of the conversion terms, any restrictions or limitations, and the market price of the underlying equity.

Benefits of Exchangeable Bonds

  1. Diversification: They offer exposure to another company or sector which provides diversification to investors.
  2. Potential for higher returns: Exchangeable bonds can offer higher returns compared to regular bonds, as they carry the risk of default of the underlying company.
  3. Flexibility: They allow investors to convert into equity in the underlying company, providing a potential for capital appreciation.

Risks of Exchangeable Bonds

  1. Default risk: They carry the risk of default of both the issuer and the underlying company, which can result in the loss of principal.
  2. Market risk: The value of exchangeable bonds can be affected by fluctuations in the stock price of the underlying company.
  3. Conversion risk: The conversion of exchangeable bonds into equity can be subject to restrictions and limitations, reducing the potential for capital appreciation.
  4. Liquidity risk: Exchangeable bonds may trade less frequently and at wider bid-ask spreads compared to regular bonds, making it difficult to sell them quickly and at a fair price.

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