Exchangeable Bonds (EB)

How an exchangeable bond works matters when a selling firm explains its terms and risks to a customer, and when the customer, after the explanation, checks what the bond is likely to earn or lose.

Bonds that may be redeemed in the underlying shares

An exchangeable bond (EB) is a bond that, depending on how a share price moves before the redemption date, may be redeemed at maturity in shares of a company other than the issuer instead of the redemption amount in cash. These shares are called the underlying shares¹. The exchangeable bond is a typical example of a structured note linked to the price of an individual stock². Structured notes in general, which combine a bond with derivatives, are covered in What Are Structured Products?.

Consider a fictional example of an exchangeable bond issued by Company B, with the shares of Company C as the underlying shares. The price of Company C's shares when the terms are set is 2,000 yen, and this price is called the initial price³.

If the share price falls to a set level (the knock-in price, 1,400 yen in the example) or below during the term, the bond knocks in⁴. Many exchangeable bonds have terms of the same form as this example. If the share price falls sharply even once during the term (the bond knocks in) and the share price at maturity is below the initial price, the bond is redeemed in a number of shares calculated at the initial price⁵. The number of shares is fixed regardless of the share price at maturity. In the example, it is 500 shares whatever the price at maturity⁶.

Terms differ from product to product. On some types, even if the bond knocks in during the term, it is redeemed at face value as long as the share price at maturity is above the knock-in price rather than the initial price⁷. On other types, the bond is redeemed not in shares but in cash equal to the market value of the shares².

Some types have no knock-in feature. The National Tax Agency's material calls one such type "plain type" (our translation). On this type, the bond is redeemed in shares if the price of the underlying shares on the valuation date, a few days before the redemption date, is below the conversion price. It is redeemed in cash equal to the face value if the price is at or above the conversion price. The conversion price is set at or below the share price on the date the terms are set. In either case, the coupon is paid in cash⁸. The Japan Securities Dealers Association's material calls the price that decides whether the bond is redeemed in shares the "reference price" (our translation)³.

In the United States, a bond that is linked to the shares of another company or a similar asset and may be redeemed in a set number of shares or in cash equal to their market value is called a reverse convertible⁹. As with an exchangeable bond, the investor in a reverse convertible is in the same position as someone who has sold a put option to the issuer¹⁰.

Redemption and profit or loss at maturity

In the example, if the bond does not knock in, it is redeemed at 1 million yen whatever the share price at maturity. If it knocks in and the share price is below the initial price, the investor receives less than the principal by the amount the price has fallen. The amount received depends on Company C's share price at maturity and on whether the bond has knocked in, as shown below. Dividends and taxes are left out.

In cases A, B, and C, the investor receives the principal of 1 million yen and the coupon of 80,000 yen. In case B, the share price at maturity is 20% below the initial price, but the bond has not knocked in, so it is redeemed at face value. In case C, the bond knocked in during the term, but the share price at maturity is above the initial price, so it is redeemed at face value⁷.

In case A, the share price has risen 20%. Had you bought 500 shares of Company C for 1 million yen, you would have made a profit of 200,000 yen, but the exchangeable bond earns only the 80,000-yen coupon. The investor does not receive the rise in the underlying shares⁹.

In cases D and E, the bond is redeemed in 500 shares. In case E, the shares are worth 500,000 yen, and even with the coupon the loss is 420,000 yen. Had you bought Company C's shares with the same 1 million yen, the loss would have been 500,000 yen, and the only difference is the 80,000-yen coupon. When it is redeemed in shares, an exchangeable bond has much the same economic effect as buying the shares¹¹.

Figure description

The profit and loss at maturity of the example exchangeable bond if it has knocked in, shown per share of Company C (2,000 yen of face value). It includes 160 yen, the 80,000-yen coupon divided by 500 shares. If the share price at maturity is 2,000 yen or above, the bond is redeemed at face value, and the profit is fixed at the 160-yen coupon. Below 2,000 yen, the profit or loss falls by 1 yen for each 1-yen fall in the share price, reaching 0 yen at 1,840 yen and −840 yen at 1,000 yen. The lower the share price, the larger the loss, while the profit is limited to the 160-yen coupon.

If the bond has knocked in and the share price at maturity is below the initial price, the profit or loss per share is the 160-yen coupon minus the difference between the initial price and the share price at maturity. In case D, this is 160 yen − (2,000 yen − 1,600 yen) = −240 yen, or −120,000 yen for 500 shares.

Splitting it into a bond and a short knock-in put

An investor who buys an exchangeable bond is in the same position as buying an ordinary bond and, at the same time, selling a put option on the underlying shares to the issuer. In return for selling the put, the investor receives a higher coupon than on an ordinary bond¹⁰. The example bond can be split into an ordinary bond issued by Company B with a face value of 1 million yen and a term of one year, and a short put on 500 shares of Company C. The put's strike price is the initial price of 2,000 yen, and the right arises only if the share price falls to 1,400 yen or below during the term (if the bond knocks in)⁴. A put that takes effect only after a knock-in like this is called a knock-in put.

Take case E to check this. After the knock-in, the share price at maturity is 1,000 yen. The buyer of the put can sell shares worth 1,000 yen to the investor for 2,000 yen, so the investor who sold the put loses 500 shares × (2,000 yen − 1,000 yen) = 500,000 yen. Subtracting this 500,000 yen from the bond's redemption of 1 million yen leaves 500,000 yen, the same as the market value of the 500 shares. The same holds if the initial price is set at 100 and the price falls to 70. The exchangeable bond pays only 70 against a principal of 100, a loss of 30, the same as for the seller of a put who must buy shares worth 70 for 100¹².

The main source of an exchangeable bond's high coupon is payment for bearing the risk of a large loss if the bond knocks in, and it corresponds to an option premium¹². However, fees that become income for the financial institution that structures the product (the dealer) are deducted from the premium of the embedded put¹³. The high coupon is also partly payment for giving up the gains the investor would have made from a rise in the shares had they held them (case A above)¹⁴. In general, the higher the coupon on an exchangeable bond, the larger the expected movement in the price of the underlying shares (volatility), and the more likely the bond is to knock in and be redeemed for less than the principal¹⁰.

Types with automatic early redemption

Some exchangeable bonds have an automatic early redemption (autocall) clause, under which the bond is redeemed before maturity if the share price on an observation date (for example, each quarter) has risen by a set margin (for example, 5%). Once the bond is redeemed early, the period over which the investor receives the high coupon also ends⁵. A multi-year example combining automatic early redemption and a knock-in is covered in Overview of Exotic Equity Products.

Some also have a clause that lets the issuer choose to redeem it early (redemption before maturity, or call)¹⁵. Automatic early redemption depends on the share price on an observation date, whereas redemption before maturity is a matter of the issuer choosing whether to redeem⁵¹⁵.

Risks borne by the investor

The main cause of losses on an exchangeable bond is a fall in the price of the underlying shares. If the bond is redeemed in shares, the investor may receive less than the principal depending on the market value of the shares delivered, and if the share price falls further after delivery, the loss grows¹.

As with other bonds, payments of principal or interest on an exchangeable bond may be delayed if the issuer's financial condition changes and its ability to pay weakens. If the investor sells before maturity, the investor may receive less than the principal, depending on the price at the time of sale³. Both risks are common to structured products, and the page "What Are Structured Products?" covers them in its section on risks common to structured products. In addition, the bond component is an unsecured obligation of the issuer, and the issuer's credit rating does not reflect market risks such as the risk that the price of the underlying shares falls below the knock-in price¹⁵.

The share price at the time you buy also affects what you receive. If the share price has fallen since the terms were set, the margin before the price at which the bond would be redeemed in shares is already narrower⁴. In the example, if you buy after Company C's share price has fallen to 1,600 yen, the price can fall only 12.5% before it reaches the knock-in price of 1,400 yen.

Because the coupon is shown as an annual rate, on an exchangeable bond with a term shorter than one year, the interest you actually receive is smaller than the rate³. For example, even at a coupon of 10% a year, a term of three months gives you about 2.5% of the face value (based on a 360-day year)¹⁶.

Notes

1. Japan Securities Dealers Association, "EB債（他社株転換可能債券）の特徴やリスクとは？" (What are the features and risks of exchangeable bonds?, in Japanese), page 1, "１．そもそもＥＢ債とは？" (1. What is an exchangeable bond?) and "〇 注意すべき事項" (Points to note). ↩ ↩²

2. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (Results of monitoring customer-oriented business conduct by distributors of investment trusts and other products, in Japanese) (June 2022), page 28, "① 商品性に関する問題点" (① Problems with product characteristics) and note 25. ↩ ↩²

3. Japan Securities Dealers Association, "EB債（他社株転換可能債券）の特徴やリスクとは？" (in Japanese), page 2, "ポイント１ 発行・償還条件等の確認" (Point 1: Checking the issue and redemption terms) in "２．ＥＢ債の商品内容を理解するポイント" (2. Points for understanding exchangeable bonds). ↩ ↩² ↩³ ↩⁴

4. Japan Securities Dealers Association, "EB債（他社株転換可能債券）の特徴やリスクとは？" (in Japanese), page 3, the note in "ポイント２ 他社株式への転換に係る事項の確認" (Point 2: Checking the terms for conversion into another company's shares) and "ポイント３ 投資判断時の対象株式の価格水準の確認" (Point 3: Checking the price level of the underlying shares when deciding to invest). ↩ ↩² ↩³

5. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (in Japanese) (June 2022), page 29, the paragraphs Ⓐ to 🄫 and Chart 22. ↩ ↩² ↩³

6. The same material, page 29, note 26. It states that if the initial price is 100 and the price falls below 70 during the term and then recovers to 75, the bond is still redeemed in a number of shares calculated at the initial price of 100. ↩

7. FINRA, "Regulatory Notice 10-09" (February 2010), "Background & Discussion," the table of redemption outcomes by share price movement (Scenarios 1 to 5) and the paragraph before it. ↩ ↩²

8. National Tax Agency, "EB債（他社株転換債）の評価" (Valuation of exchangeable bonds, in Japanese), "（理由）" (Reasons) and "【EB債の一般的な仕組み】" (How exchangeable bonds generally work). ↩

9. FINRA, "Regulatory Notice 10-09" (February 2010), "Background & Discussion," first and second paragraphs. ↩ ↩²

10. FINRA, "Regulatory Notice 10-09" (February 2010), "Background & Discussion," third paragraph ("In effect, the investor in the reverse convertible is selling the issuer a put option"). ↩ ↩² ↩³

11. Japan Securities Dealers Association, "EB債（他社株転換可能債券）の特徴やリスクとは？" (in Japanese), page 2, the opening paragraph of "２．ＥＢ債の商品内容を理解するポイント" (2. Points for understanding exchangeable bonds). ↩

12. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (in Japanese) (June 2022), page 29, the paragraph beginning "こうした EB 債の商品性は" (The product characteristics of such exchangeable bonds) and note 27. ↩ ↩²

13. The same material, page 30, the paragraph beginning "また、オプションを組み込む際" (In addition, when embedding an option). ↩

14. The same material, page 29, the paragraph beginning "また、相対的な高金利は" (In addition, the relatively high interest rate). ↩

15. FINRA, "Regulatory Notice 10-09" (February 2010), "Background & Discussion," the paragraph after the table of redemption outcomes. ↩ ↩² ↩³

16. FINRA, "Regulatory Notice 10-09" (February 2010), "Communications With the Public and Other Sales Practices," the paragraph on presenting annualized yields. ↩ ↩²

17. The same material, "Suitability" and "Eligible Accounts." ↩