What Is Exchangeable Debt?
An exchangeable debt is a type of hybrid debt security that can be converted into the shares of a company other than the issuing company (usually a subsidiary). Companies issue exchangeable debt for a number of reasons, including tax savings and divesting a large stake in another company or subsidiary.
- Exchangeable debt is a hybrid debt security that can be converted into the shares of a company other than the issuing company; usually a subsidiary.
- Primary reasons that companies issue exchangeable debt are for tax savings and divesting large stakes in another company or subsidiary.
- Because of the convertible nature of exchangeable debt, they carry a lower coupon rate and offer a lower yield than comparable straight debt (debt without a conversion provision).
- The conversion price, the conversion ratio, and the debt maturity are specified in the bond indenture at the time of issue of exchangeable debt.
- The price of an exchangeable debt is the price of a straight bond plus the value of the embedded option to exchange.
Understanding Exchangeable Debt
Straight debt can be defined as a bond that does not give the investor the option to convert into equity of a company. Since these investors do not get to participate in any price appreciation in the shares of a company, the yield on these bonds is typically higher than a bond with an embedded option to convert. One type of bond that has a convertibility feature is the exchangeable debt.
An exchangeable debt is simply a straight bond plus an embedded option which gives the bondholder the right to convert its debt security into the equity of a company that is not the debt issuer.
Most of the time, the underlying company is a subsidiary of the company that issued the exchangeable debt. The exchange must be done at a predetermined time and under specific conditions outlined at the time of issuance.
In an exchangeable debt offering, the terms of the issue, such as the conversion price, the number of shares into which the debt instrument can be converted (conversion ratio), and the debt maturity are specified in the bond indenture at the time of issue.
Exchangeable Debt vs. Convertible Debt
Exchangeable debt is quite similar to convertible debt, the major difference being that the latter is converted into shares of the underlying issuer rather than shares of a subsidiary as is the case with exchangeable debt.
In other words, the payoff of exchangeable debt depends on the performance of a separate company, while the payoff of convertible debt depends on the performance of the issuing company.
An issuer decides when an exchangeable bond is exchanged for shares whereas with a convertible debt the bond is converted into shares or cash when the bond matures.
Valuing Exchangeable Debt
The price of an exchangeable debt is the price of a straight bond plus the value of the embedded option to exchange. Thus, the price of an exchangeable debt is always higher than the price of a straight debt given that the option is an added value to an investor’s holding.
The conversion parity of an exchangeable bond is the value of the shares that can be converted as a result of exercising a call option on the underlying stock. Depending on the parity at the time of exchange, investors determine whether converting exchangeable bonds into underlying shares would be more profitable than having the bonds redeemed at maturity for interest and par value.
Divesting With Exchangeable Debt
A company that wants to divest or sell a large percentage of its holdings in another company can do so through exchangeable debt. A company selling off its shares hastily in another company may be viewed negatively in the market as a signal of financial health deterioration.
Also, raising an equity issue may result in the undervaluation of the newly issued shares. Therefore, divesting using bonds with an exchangeable option may serve as a more beneficial alternative for issuers. Until the exchangeable debt matures, the holding company or issuer is still entitled to the dividend payments of the underlying company.