When you buy a bond with an attached warrant, the warrant gives you the right to buy a certain number of fixed-price shares of the stock of the company that issues the bond. You are not obligated to purchase the stock, and the price specified on the warrant may be different from the price at which the stock is trading on the day you buy your bonds.
Reason for Warrants
A company issues bonds when it needs to borrow money from public or private investors. Bonds are physical or electronic documents that guarantee whoever purchases them a fixed or variable rate of interest. Companies can sell bonds with warrants that allow buyers to purchase stock at a certain price, often within a given amount of time. They often follow this strategy when they want to offer bonds at a percentage rate lower than is usual for companies with a similar value or performance rating.
Mechanism and Terminology
Warrants are considered detachable, which means they can be sold or redeemed separately. The price at which the warrant holder can buy shares of stock is called the strike price or exercise price. Most warrants can be traded on financial exchanges, and in some cases companies provide incentives to bondholders who sell or exercise their warrants before the warrants expire. For example, a company may not pay a dividend to a bondholder who still has outstanding warrants.
Exercising and Selling Warrants
When warrants are traded independently of their accompanying bonds, they can rise in price as the underlying stock price rises. The exercise price of a warrant on its day of issue is usually higher than the price of the stock on the same day. Nevertheless, the price of the stock may rise during the period of validity for the warrant, which can be as long as five years. When this happens, the price of the warrant rises as well. The bondholder who received the warrants can either purchase the stock at a lower price or sell the warrants at an advantageous price.
Convertible bonds are similar to bonds with warrants in that both types of securities enable the buyer to purchase company stock at a certain price. The difference is that holders of bonds with warrants retain the bonds and either sell the warrants or use additional funds to buy stock, whereas investors who buy convertible bonds use the bonds to buy stock. Call options are also somewhat similar to warrant bonds in that they give holders the right to buy stock at a certain price and can be traded. Call options have no underlying value, however, so if they sink to below the price that an investor pays for them, the investor does not have a bond that continues to hold value.
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