Question

Explain what is the differences and similarities of bond with warrant and convertible bonds as part of hybrid financing. Please also explain the advantages and disadvantages of each of particular hybrid financial instrument.

Answer 1

A Hybrid financial instruments are those instruments which has the features of both a debt instrument and an equity. These are choosen by the investors as a part of risk mitigation techniques or as an insurance. Some of the instruments are Preference shares , convertible bonds, warrants, innovative hybrids etc.

A Bond with warrant is an ihybrid nstrument which gives the holder the right, but not the obligation, to buy or sell a specific bond at a predetermined price within a time period. Warrant is a derivative instrument and it comes along with the underlying instrument. Warrants resemble option in many aspects and the main difference is that when a warrant is exercised the investor recieves newly issued stocks rather than outstanding stocks.

A Convertible bond is also another hybrid instrument. This is similar to bond in terms of payments and yield whereas the bond instrument can be converted to predetermined number of stocks in the company. This is usually done at the time that are specified in the contract and the bond holder has the discretion of using the right. Unlike Warrants the price at which the bonds are converted in Convertible bonds are not fixed and determined by the market price.

Benefits & Disadvantage of bond with warrants

Pros

• Fixed interest payments till the investor choose the right to purhase the stocks.

• Default risk security

• Investor get benefit from the fixed price at which the bonds are converted to equity if the share price appreciate in the market

• Companies can pay lower interest rate citing they are selling the rights as well

Cons

• Seperate premium for warrant has to be paid by investors

• Low coupon rate for investors and less attractive for long term

• Share dilution can happen if investors use their rights which can affect EPS

Benefits & Disadvantage of Convertible bond:

Pros

• Fixed interest payments till the investor choose the right to purhase the stocks.

• Default risk security

• Advantage for the company as they raise capital without diluting their shares initially.

• Companies can pay lower interest rate citing they are selling the rights as well

Cons

• Low coupon rate for investors and less attractive for long term

• Share dilution can happen if investors use their rights which can affect EPS

• The price at which the bond is converted might be too high since convertion happens on the market rate of stocks.