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What are convertible and exchangeable bonds?

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An embedded option in a corporate bond, usually subordinated debentures, granting holders the right to convert the security into a predetermined number of shares of a certain class of equity of the bond issuer, typically common stock, is a conversion feature.  A conversion feature may apply to only part or all of the convertible’s life.  A convertible bond contains a call option to buy the underlying security, it allowing the holder to take advantage of favorable movements in the underlying’s price.  To account for a convertible bond by the issuer, the host contract would be recognized as a callable bond with a redemption option and the conversion feature as a put option.

An exchange feature is an embedded option in a corporate bond that grants the holder the right to convert (exchange) the bond for equity of a firm different to the bond issuer.  The equity into which the bond is exchangeable is often held by the bond issuer or its parent company.  Exchangeable bonds have become an important means by which companies, especially holding companies, can divest themselves of their cross-shareholdings without dumping shares in the market and depressing prices.

Although convertible bonds (including exchangeable bonds) have lower coupons and stated yields to maturity than nonconvertible bonds, their actual return can exceed the bond’s quoted yield to maturity if the conversion option increases in value above conversion parity.  Along with the conversion privilege granted to the bondholder, most convertible bonds are callable at the issuer’s option, while some are puttable.

The advantages of a convertible bond for the issuer include:

  • It requires a lower coupon than a nonconvertible;
  • Funded debt is reduced as conversion occurs, thus improving leverage and coverage ratios;
  • Conversions normally have little effect on the underlying’s market price since they usually take place in small amounts over an extended time period; and
  • Immediate dilution of primary earnings per share is avoided, which would otherwise occur with the issuance of common stock.

Forced conversion is the issuer’s redeeming of a callable convertible bond when the price of the underlying shares is above the bond’s conversion price in order to force bond conversion into capital stock to increase equity capital, thereby improving leverage and coverage ratios.  This assures the issuer that the bonds will be retired without any cash redemption payment and that the carrying value of the bonds becoming equity, thus strengthening the balance sheet and enhancing future debt capability.

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