Exchangeable bonds are a way for countries and financial institutions to borrow money from capital markets with specific terms. In some cases, countries may make use of financial institutions such as investment banks to underwrite or facilitate the issuance of these bonds to supplement monetary policy. Otherwise, exchangeable bonds can be issued by central banks and traded via bond exchanges.
Exchange
A key feature of exchangeable bonds is they can be traded for stock held by, but not of the issuer according to Reuters. In other words, exchangeable bonds are similar to convertible bonds because they can be exchanged for stock, but not the stock of the issuer. The price at which stocks are acquired is important in receiving an equitable exchange for the bond. For example, if a 10 year bond with a face value of $1000.00 yields 4 percent per annum at an inflation rate of 3 percent, the value of the stock should equal the present value of the annual payments plus the bond’s present value per the New York University Stern Shcool of Business bond valuation method i.e. $931.46 at the time of issue.
Rates
Rates on exchangeable bonds vary, but have been as high as 5.25 percent for Portuguese exchangeable bonds and as low as 1.5 percent for those issued by KwG Bank Group. The yield of bonds is linked to the credit rating and demand for the bonds, but also by how much an issuer is willing to borrow money for. To limit opportunity cost, the rate at which exchangeable bonds ideally equal the highest yields and lowest price of existing bonds with the same credit rating in either primary or secondary bond markets. Furthermore, if bonds are purchased in a secondary market their purchase price can also be discounted if new issues of the same bond offer a higher rate.
Terms
Issuers of exchangeable bonds can do so with conditions such as bond recall or cash exchange option. This is evident in exchangeable bonds issued by the Portuguese Government. Moreover, these particular exchangeable bonds were issued with the understanding that the issuer would maintain ownership of the exchangeable amount of Galp Energia shares until traded. However, the issuer also had the option to keep those shares and instead offer cash with value equal to the average trading price of those shares in exchange for the bonds. Additional conditions of exchangeable bonds include the qualifying exchange period and recall of the bonds prior to their maturity date.
Risks
Exchangeable bonds that are rated by agencies such as Moody’s assist investors in evaluating the risk level of the bonds and the credibility of the issuer. In some cases ‘events’ such as legislative adjustments can cause the terms of an exchangeable bond to change. Predicting these events is not an exact science but can be assisted with a review of the economic and market trends in addition to analysis of existing bond yield curves. Other risk includes opportunity cost and market risks such as transaction speed, or inaccurate inflation discount rates and/or risk premium in the case of exchangeable bond repurchases.