A warrant gives the holder the right to buy shares of common stock at an exercise price for a given period. Typically, warrants are issued in a package with privately placed bonds. Afterward they become detached and trade separately.
A convertible bond is a combination of a straight bond and a call option. The holder can give up the bond in exchange for shares of stock.
Convertible bonds and warrants are like call options. However, there are some important differences:
Warrants and convertible securities are issued by corporations. Call options are traded between individual investors.
Warrants are usually issued privately and are combined with a bond. In most cases the warrants can be detached immediately after the issue. In some cases, warrants are issued with preferred stock, with common stock, or in executive compensation programs.
ii. Convertibles are usually bonds that can be converted into common stock.
iii. Call options are sold separately by individual investors (called writers of call options).
Warrants and call options are exercised for cash. The holder of a warrant gives the company cash and receives new shares of the company's stock. The holder of a call option gives another individual cash in exchange for shares of stock. When someone converts a bond, it is exchanged for common stock. As a consequence, bonds with warrants and convertible bonds have different effects on corporate cash flow and capital structure.
Warrants and convertibles cause dilution to the existing shareholders. When warrants are exercised and convertible bonds converted, the company must issue new shares of common stock. The percentage ownership of the existing shareholders will decline. New shares are not issued when call options are exercised.
Many arguments, both plausible and implausible, are given for issuing convertible bonds and bonds with warrants. One plausible rationale for such bonds has to do with risk. Convertibles and bonds with warrants are associated with risky companies. Lenders can do several things to protect themselves from high-risk companies:
They can require high yields.
They can lend less or not at all to firms whose risk is difficult to assess.
They can impose severe restrictions on such debt.
Another useful way to protect against risk is to issue bonds with equity kickers. This gives the lenders the chance to benefit from risks and reduces the conflicts between bondholders and stockholders concerning risk.
A puzzle particularly vexes financial researchers: Convertible bonds usually have call provisions. Companies appear to delay calling convertibles until the conversion value greatly exceeds the call price. From the shareholders' standpoint, the optimal call policy would be to call the convertibles when the conversion value equals the call price.
