A bond cum warrant is a bond with a detachable subscription (generic) warrants that may be traded separately from the bond.  Detachable warrants are also issued with preferred stock.  Like a subscription right, the holder of a bond with warrants attached is long the bond and a call option on the underlying.  Unlike a convertible bond, a bond warrant is detached and traded separately from the host bond.  Depending on its terms, a bond warrant can be exercised either with cash or by exchanging it at the par value of the bond with which it is issued.

A warrant issued with a bond acts as a “sweetener” or “kicker” to make a bond issue more attractive to investors and to reduce the cost of the host issue.  The cost of the bond issue is reduced because investors are usually willing to accept a lower return on the host security in exchange for a separately tradable asset.  When the price of the underlying increases above the exercise price, the warrant’s holder can exercise the warrant and buy the underlying below the market price or sell the warrant in the market.

Naked warrants are issued on its own, without any host security, commonly as basket warrants and index warrants.  The underlying of a basket warrant is the shares of a group of different third-party companies, while the underlying of an index warrant is a stock market index.  Basket and index warrants are commonly written by banks to generate premium income.

A basket warrant typically written by banks granting the holder the right to buy from the writer the portfolio of equity issued by third parties or an index at a fixed strike price is a covered warrant.  The writer of covered warrants must provide one-to-one cover.  The warrant’s writer guarantees that the portfolio of assets will be available upon the warrant’s exercising, which makes the financial standing of the writer a critical consideration.

Subscription Warrants Compared to Covered Warrants
Issuer Underlying Issuer Investment Banks
Purpose A sweetener, typically issued attached to bonds (bonds cum warrants) Premium income for the issuer
Option Type Call option Call or put option
Underlying Common shares of the warrant’s issuer Equity of 3rd-party, index or baskets of stock
Impact on Capital of Underlying Issuer Increases capital and shares outstanding No effect on owners’ equity
Life of Instrument Longer than covered warrants Longer than traded options

A puttable warrant is a basket warrant giving the holder the right to sell (put) the underlying portfolio back to the issuer at a fixed cash redemption value.  This feature limits the risk of investing in the warrant.

When the warrant’s exercise price is lower than the underlying’s market price, the warrant has intrinsic value, which is calculated using the following formula, where IV is the warrant’s intrinsic value, AP is the market price of a unit of the underlying, EP is the warrant’s exercise price (strike price), and n is the number of units of the underlying asset that can be bought with each warrant:

IV = (AP − EP) x n

Related Items