What are warrant-backed bonds and how do they work?

In the current economic context, characterized by a growing interest in diversified investment instruments, bonds cum warrants represent an interesting solution for a good portion of investors. This financial instrument, which combines the characteristics of traditional bonds with an additional option linked to a warrant, presents itself as an ideal solution for those seeking stable returns but also wanting potential exposure to the stock market.

Bonds cum warrants find space in a context in which central banks maintain uncertain monetary policies and investors are increasingly looking for opportunities that balance risk and return. Unlike standard bonds, these offer an opportunity to participate in the rise of the stock market without compromising the safety of the bond capital. It is not surprising that they are used by both corporate issuers and government bodies as a tool to attract investors.

What are warrant bonds: meaning and definition

Warrant bonds are hybrid financial instruments that combine a traditional bond with a warrant. But what is a warrant?

The warrant is an option that allows the holder (through a right) to purchase or subscribe for one or more shares of the issuer or another company at a certain price by a specific date.

From a technical point of view, the bond provides the holder with a stable income stream through periodic coupons and the repayment of capital at maturity. The warrant, on the other hand, offers a separate option to invest in shares, with the potential to obtain significant gains if the price of the shares exceeds the strike price of the warrant.

These instruments are often issued by companies seeking capital at competitive costs or by government bodies that want to incentivize investors to support specific projects. Bonds cum warrants should not be confused with convertible bonds: while the latter convert directly into shares, the former keep the nature of the bond and the warrant separate.

Furthermore, bonds cum warrants can have different characteristics depending on the issuer. Some provide warrants that can be exercised only during certain periods, while others allow continuous exercise. This makes them a flexible and adaptable instrument to the needs of different types of investors.

How a warrant-backed bond works

Warrant-backed bonds work by synergy between the bond component and the warrant, which operate independently but complementary.

When an investor buys a warrant-backed bond, they acquire a fixed income security and, at the same time, an option to buy shares at a predetermined price.

Bond component

• The bond portion of the security functions like a regular bond. The issuer promises to pay periodic coupons, usually at a fixed rate, and to repay the principal at maturity. This provides investors with a stable and predictable return, regardless of the performance of the warrant or the stock market.

Warrant Component

• The warrant, on the other hand, represents a right (and not an obligation) for the investor to buy a certain number of shares at a predetermined price, known as the strike price. If the market price of the shares exceeds the strike price before the warrant expires, the investor can exercise the option and earn a profit on the difference between the two prices. Otherwise, the warrant expires worthless, but the investor still retains the return from the bond component.

Advantages and Risks for Investors in Cum Warrants

A key aspect of cum warrant bonds is that the warrant can be separated from the bond and sold or traded separately, depending on the terms of the issuer. This offers significant flexibility to investors, who can decide to cash in on the warrant without giving up the stability offered by the bond.

From the issuer’s perspective, warrant-backed bonds represent an opportunity to raise capital at a lower cost than traditional bonds. In fact, the earnings potential associated with the warrant allows them to offer lower interest rates on bonds.

Benefits for investors include the ability to diversify their portfolio and earn additional returns through the warrant. However, there are also risks, as in all investments: the value of the warrant depends on market conditions and the performance of the underlying stock, while the bond component may be subject to credit and interest rate risk.

The differences between warrant-backed bonds and convertible bonds

Before looking at the differences - partly announced - it is important to understand what a convertible bond is. Let’s do a quick review.

Convertible bonds are hybrid securities, that is, they are in an intermediate position between bonds and shares. Their holder has the right to decide whether to remain a creditor of the issuing company for the entire duration of the loan, or, in certain pre-established periods, to convert their status from creditor to shareholder on the basis of an exchange ratio predetermined in the issuing regulations.

The conversion option represents an option that is implicitly sold by the issuer to the subscriber; in exchange for this, the bondholder receives a return calculated on the basis of a nominal rate lower than that of an ordinary bond of the same characteristics, since this difference is the premium of the option. Convertible bonds cannot be issued at a price lower than their nominal value and must be offered as an option to shareholders.

We have already mentioned, therefore, that cum warrant bonds are similar to convertible bonds in that the holder has the right to purchase a certain quantity of shares at a pre-established price. However, cum warrant bonds differ from convertible bonds in several respects.

• This right is incorporated into an instrument, the warrant, which can be detached from the bond and circulate independently on the market.
• The bond continues to exist even after the exercise of the warrant (while the convertible bond ceases to exist upon conversion).
• To purchase the underlying shares, an additional outlay of money is required, in addition to the sum already invested in the bond, equal to the pre-established exercise price multiplied by the number of underlying shares.

In essence, the difference between a convertible bond and a cum warrant bond is that, while the conversion option cannot be separated from the starting title, the warrant can be traded separately. Furthermore, another significant difference is due to the warrant, which can be converted at any time of the year, not only in some established periods as happens with convertible bonds. This faculty is significant because depending on the changing market conditions, the holder may want to convert their bonds without any restriction.

Similarly to convertible bonds, cum warrant bonds can be issued with a direct method, when the issuer of the underlying shares coincides with the issuer of the bonds, or with an indirect method, when the underlying shares are of a different company.

Original article published on Money.it Italy. Original title: Cosa sono le obbligazioni cum warrant e come funzionano