Bonds that can be converted into predetermined numbers of shares of common stock of companies other than their respective issuers are called exchangeable bonds. These bonds are similar to convertible bonds. The main difference is that convertible bonds can only be converted into the shares of their respective issuing companies.
Nevertheless, in consideration of the aforementioned, it would appear that exchangeable bonds have a greater degree of flexibility than other bonds with other embedded options. These bonds also appeal to investors who might want to take advantage of potential upticks in the stock market. This article identifies the pros and cons of exchangeable bonds.
Pros: Advantages of Exchangeable Bonds
Exchangeable bonds can provide their bondholders both the fixed-income nature of bonds and the potential for capital appreciation of common stocks. The embedded option to exchange gives investors the freedom to invest in bonds while also enabling them to choose to invest in stocks. This is similar to the advantages of convertible bonds.
Furthermore, considering their difference from bonds with a straight conversion option, these bonds offer greater flexibility. Purchasing and owning exchangeable bonds can be an attractive option for investors seeking a balance between passive income generation and wealth accumulation. The following are the specific advantages of exchangeable bonds:
• Flexible Investment Vehicle: Remember that exchangeable bonds can be converted into the shares of specific companies other than the issuing companies. This conversion can be useful in situations that require changing a particular investment strategy or in instances that involve evolving investment preferences and risk appetite.
• Moderate or Aggressive Options: Bonds are safer investments than stocks and they are ideal for moderate to conservative investors. However, in the case of convertible bonds and exchangeable bonds, holding these debt instruments provide bondholders with an option to switch from moderate investment to aggressive investment.
• Has Downside Protection: Another advantage of exchangeable bonds is their potential for upside participation in the stock market. Furthermore, despite having lower yields than traditional bonds, these bonds offer investors downside protection in case the stock prices or market value of relevant companies do not increase as expected.
• Diversification of Portfolio: Purchasing and holding these bonds can provide diversification benefits. Remember that these bonds provide the potential for upside participation in the stock market while offering reduced downside risk in which investors can remain bondholders if stock participation is not a viable option.
Cons: Disadvantages of Exchangeable Bonds
One of the main downsides of exchangeable bonds is that their coupon rates and yields are often lower than traditional bonds and callable bonds. Investors who want to remain invested in the bond market through these bonds should expect moderate to conservative investment gains. The option to have them exchanged for shares eases this drawback.
However, because stock investing has risks, it is also important to note that converting these bonds into shares exposes investors to the downside of owning stocks. Bonds also have risks but they are suitable investments for individuals with moderate to conservative risk profiles. Below are the specific disadvantages of investing in exchangeable bonds:
• Lower Coupon and Yields: These bonds tend to have lower coupon rates and yields compared to traditional bonds and callable bonds. These might not be suitable for certain investors with a moderate risk profile who want to maximize the potential of their investment while remaining invested in the bond market.
• Forced Conversion to Stock: Another disadvantage of exchangeable bonds is that their issuers can force bondholders to have them exchanged for shares of common stock. The investors would then end up being stuck owning unwanted shares of companies that either lack potential or are unaligned with their investment purpose.
• Investment Dilution Risk: These bonds also expose investors to the risk of having their investments diluted once they are converted into shares of underperforming companies or those with no potential for growth. Growth in stock prices would also mean that the bonds would be converted into a limited number of shares.
• Exposure to the Stock Market: Remember that stocks are a riskier investment than bonds. Forcing bondholders to have their exchangeable bonds converted into shares of common stocks would mean exposing them to the inherent risks of stock investing. This might not be ideal for investors with moderate to conservative risk profiles.
