Contingent convertible bonds (cocos) have their advantages. But they also carry a risk that has become much more evident since the bull market ground to a halt.
The problem with cocos is that during a recession, jittery investors are more likely to force issuers to pay them off before maturity. The issuing companies must then scramble to raise new capital to cover the redemption.
Why the run to redeem? If the underlying stock price of cocos falls with the market, bondholders may try to cash out by exercising the bond's put option, says Tom Marshella, co-head of Moody's Investors Service's leveraged finance team. And the lower the credit rating of the issuer, the more likely the investor is to sell the bonds back, he adds.
The experience of Tyco International Ltd., an investment-grade company, puts the put theory to the test. In November 2000, Tyco issued $3.5 billion worth of zero-coupon notes, the first coco issue in the United States. The bonds reached their first put date on November 17, 2001, about a month after the company announced its intent to use cash to pay off bondholders that chose to put back the notes to the company. In that year's time, Tyco's stock price dipped below 40 before climbing to its current 58.
The cash wasn't at risk for long, as only $10 million worth of the notes were redeemed. What's more, Standard & Poor's analyst Cynthia Werneth comments that S&P believed in the conglomerate's ability to raise capital quickly, even if it had been forced to buy back all of the convertibles. "The real issue is that the convertibles afforded Tyco little financial flexibility, other than to react to the bondholders' decision," says Tom Marthaler, senior managing director at ABN Amro's Chicago Capital Management. -- M.L.
Put It Here
Coco issues as of November 2001
- Number of issues 64
- Total proceeds $39.3 billion
- Convertible issues that are cocos 45%