Exchangeable Bonds – A Hybrid Financial Derivative with Opportunities and Risks

Thesis, June 2005, by Frédéric Heller

in corporate finance at the Swiss Banking Institute of the University of Zurich

This thesis analyzes and evaluates the significance of exchangeable bonds (XBs). It explains the structure of and the way that XBs function. It identifies the reasons for issuing XBs and provides an economic assessment of the opportunities and risks associated with this financial product.

Executive summary

This thesis analyzes and evaluates the significance of exchangeable bonds (XBs). It explains the structure of and the way that XBs function. It identifies the reasons for issuing XBs and provides an economic assessment of the opportunities and risks associated with this financial product.

Part I looks at convertible bonds (CBs) in general and at XBs in particular. The differences between these two instruments are highlighted: In the case of a CB, the bond component can be converted into shares of stock in the issuing company; in the case of an XB, the bond component can be exchanged into shares of stock in a company other than the issuer. The components, the structure, the way of functioning and the theoretical price trends are explained. Part I also examines mezzanine financing and touches on the fair view concept in the new accounting regulations.

Part II begins with a historical outline of CBs and XBs. This is followed by a description of the market for XBs and an analysis of the global market development by region. The issuing prerequisites of this niche product are the specific stock, the market and the rating. Part II then considers the issuing reasons from the perspective of the issuer (financial, corporate policy-related, tax-related, government policy-related).

Part III provides a comprehensive economic analysis. Two motives for issuing XBs are articulated: (1) the motive of divesting equity holdings and raising capital from the perspective of companies and (2) the motive of trading from the perspective of banks. The motive of divesting equity holdings also applies to the government. Part III also provides an in-depth examination of the opportunities and risks for the individual issuer groups – companies, banks and the government. This analysis is also extended to the key investor groups: private investors, institutional investors and hedge funds. For these different investor groups, there are various reasons to buy XBs: Private and institutional investors are driven by an investment motive, whereas hedge funds are driven by a trading motive.

Remarkably, no financial distress segment is apparent for XBs (ceteris paribus), which means that they offer an interesting diversification advantage. CBs have generally been very successful over the last ten years. An initial XB boom phase began at the end of the 20th century, spurred by tax advantages in Europe. As a result, many companies shed their cross-holdings in what was tantamount to a veritable sell-off of equity stakes in third-party companies. A second boom phase began at the beginning of the 21st century and has chiefly promoted the privatization of government-owned businesses up to now. XBs frequently involve illiquid shares with a small market capitalization. The demand for XBs is even so large that banks need to expand the supply and are issuing their own XB-like products as structured products (SPs) to satisfy their clients. In view of the complex treatment and niche function of XBs, the XB architecture holds the potential for specialization on the part of financial intermediaries. A number of companies have already focused on CBs. Moving further in the direction of XB specialization should represent a significant opportunity for this industry. In a general sense, the financial market is made more complete by XBs. And XBs should continue to play a leading role in the privatization process. This was underscored repeatedly by the interviewees.

Academically, XBs are extremely interesting since they offer a very broad financial/economic spectrum and many starting points for more in-depth and precise studies. It should remain very exciting to follow how resourceful financial engineers continue to refine the XB market through new and exotic products with innovative attributes. Allianz AG recently broke through another barrier by issuing BITES (Basket Index Tracking Equity-linked Securities). These BITES are DAX-linked mandatory exchangeable bonds, which apart from the index link have a total of three underlying stocks. The issuer may choose whether this mandatory XB is exchanged into shares of BMW AG, Siemens AG or Munich Re. There appears to be no limits to the future development possibilities for XBs.