When you hold a simple convertible note or bond, you can exchange it for shares of the company that issued the bond, making you a shareholder instead of a partial owner. An exchangeable note is a special kind of convertible security that can be exchanged for stocks in a company of which the original bond issuer has an ownership stake.
The main difference is that the stock you’ll own after converting an exchangeable bond is not from the same company that you bought the bond from. Both types of investments combine the risks for higher payoffs with the sure payoff you receive from strict bond investing. The issuers of exchangeable and convertible bonds usually profit by the exchange because they don’t have to pay off the bond interest form the original contract. At the same time, you receive a potentially higher payoff if the stock price increases.
Convertible securities are another form of stock investments. When you convert an exchangeable or simple convertible bond, you’re allowed the face value of the bond. Issuers like the convertible securities because they can usually increase their funding by selling bonds and converting them when the share price increases, allowing them to trade fewer shares for the same amount of investment. The instruments provide investors with safe investing methods that combine the best of equity derivatives and straight bond purchases.
Added features to the convertible securities make them even more attractive as investments. A call option allows the company that issued the bonds to convert the bonds into stocks at a predetermined future date when the stock reaches a certain price. All bond holders convert to stock when the call option is due. A put option, on the other hand, allows you to set the predetermined stock price at which you’ll convert your bonds, assuring you receive sufficient interest on your initial investment. Both convertible and exchangeable notes can attach the call or put options at the time you buy them.
Straight convertible bonds have few risks and usually contain straightforward rules about when and how you can convert to stocks. Exchangeable bonds on the other hand can get complicated. The company that issues your stocks may be located in a jurisdiction that complicates your taxes or reporting procedures. Oftentimes, the issuing company creates a subsidiary to which they convert your bonds, keeping the investments within the same family. The bond issuer itself may be a subsidiary of a larger parent organization and provide considerable tax benefits when you switch to stocks, depending on where the home office is located. You need to verify the potential risks when investing in exchangeable bonds to avoid tax and legal complications.