DEFINITION of '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.

BREAKING DOWN '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 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. Because of the exchange provision, exchangeable debt generally carries a lower coupon rate and offers a lower yield than comparable straight debt, as is the case with convertible debt.

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 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.

RELATED TERMS
  1. Debt Exchangeable for Common Stock ...

    Debt exchangeable for common stock (DECS) is a convertible security ...
  2. Convertible Bond

    A convertible bond is a bond that can be converted into a predetermined ...
  3. Busted Convertible Security

    A busted convertible security is a convertible bond where the ...
  4. Mandatory Convertible

    A mandatory convertible is a type of convertible bond that has ...
  5. Debt Issue

    A debt issue is a financial obligation that allows the issuer ...
  6. Convertible Subordinate Note

    A convertible subordinate note is a short-term debt security ...
Related Articles
  1. Investing

    An Introduction to Convertible Bonds

    Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex than they really are.
  2. Investing

    3 Best High-Yielding Convertible Bond Mutual Funds (LACFX, FACVX)

    LACFX,FACVX,VCVSX: Learn about three of the highest-yielding options available.
  3. Investing

    CWB: SPDR Barclays Convertible Secs ETF

    Read an in-depth analysis of the SPDR Barclays Capital Convertible Bond ETF, which tracks an index of high-growth potential convertible bonds.
  4. Investing

    Debt Exchanges Are The Latest Push

    Many companies are trying to cut debt levels by exchanging existing debt for a combination of new debt, cash and stock.
  5. Investing

    13 Pre-Issue Corporate Bond Questions For Businesses

    When a company needs more funding, there are many options. Corporate bonds is just one of them.
  6. Investing

    Introduction to Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
  7. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  8. Insights

    How Debt Limits A Country's Options

    While debt is fundamentally necessary to the operation of a national government, it can also be limiting and dangerous.
  9. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
RELATED FAQS
  1. Where Does Stock From Convertible Bonds Come From?

    Convertible bonds are considered a combination of debt and equity. Find out how a debt instrument converts into shares of ... Read Answer >>
  2. Why would a corporation issue convertible bonds?

    Discover how corporations issue convertible bonds to take advantage of much lower interest rates as a result of a conversion ... Read Answer >>
  3. Can Private Corporations Issue Convertible Bonds?

    Find out why a "private corporation" isn't suited to issue convertible bonds. Determine what prevents this move into a company's ... Read Answer >>
Trading Center