What are hybrid securities (equity plus debt) that commercial banks commonly issue?
What are convertible bonds?
Convertible bonds are corporate bonds with a call option (right to purchase) on the company’s shares. It’s a hybrid investment that combines features of both bonds and stocks, offering the fixed income of a bond and the potential for growth from stock ownership.
These can be attractive to issuers because they bear a lower coupon than a straight bond. The investor gets a lower running return but the chance for a capital gain as he will only convert when the share price is above the conversion price. The convertible bondholder is in a similar position to a holder of a bond plus warrant (a call option on the shares) but different in that, at conversion, the convertible bondholder will give up the bond in order to exercise the call option. The bond-with-warrant holder can exercise the warrant for cash and keep the bond. In practice, bond-with-warrant issues usually split after issue with the bonds and warrants held by different investors.
An example of convertible bonds would be a company issuing bonds that can be converted into shares of the company’s stock. Suppose a company wants to raise capital for growth but is not yet ready to issue stock or wants to avoid diluting existing shareholders. The company decides to issue convertible bonds that offer investors a fixed income, but also the option to convert the bond into shares of the company at a predetermined price. If the company performs well and the share price increases, the bondholders can convert their bonds into shares and benefit from the increase in value. However, if the company does not perform as expected and the share price falls, the bondholder can choose to continue receiving the fixed income payment or to convert their bond into a smaller number of shares.
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 similar to 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.
What is Mezzanine Debt?
Mezzanine Debt is medium term debt provided by a specialised mezzanine lender or mezzanine department of a commercial bank. It often has an “equity-kicker” attached to it, in the form of a warrant i.e. the debt equivalent of a bond-with-warrant issue. The debt will normally be subordinated to other debt and carry a high rate of interest. This type of debt is most often seen in leveraged buy-outs.
It is a higher-risk, higher-reward investment compared to traditional debt, and often comes with a higher interest rate. Mezzanine debt is used by companies looking for growth capital and are usually not able to secure traditional bank loans. The debt is usually unsecured, meaning that it is not backed by any collateral, and the lender may receive a combination of interest payments and a share of the company’s profits or equity. In simpler terms, mezzanine debt is a type of financing that offers higher potential returns than traditional debt, but also carries a higher level of risk.
An example of mezzanine debt would be a company that wants to expand its business but is unable to obtain a traditional bank loan. The company approaches a private equity firm or institutional investor to obtain mezzanine financing. The lender provides the company with the capital it needs to grow in return for a higher interest rate than a traditional loan and possibly a share of profits or equity. The company can use the capital to invest in new equipment, hire more employees, or expand into new markets. If the business is successful and its value increases, the mezzanine debt holder may receive a substantial return on its investment through the combination of interest payments and equity. However, if the company does not perform as expected, the mezzanine debt holder may end up with a lower return or even a loss.