Who Needs Equity?

With new stock offerings going nowhere, capital-hungry issuers are turning instead to zero-coupon convertible bonds.


After financing two major acquisitions last year through a $1.1 billion bond offering, Arrow Electronics Inc. planned to issue new equity to reduce its debt ratio. But Arrow found the equity market unreceptive. "We waited," says CFO Samuel Leno, "but the market went from bad to worse as the year went on." Stock in the $13 billion company, like that of many in the electronics distribution sector, bounced up and down, ending the year at $28 a share, more than a third below its April high of $46. "Issuing straight equity was not really an option at that point," explains Leno.

So Arrow, like an increasing number of companies these days, opted instead to issue convertible bonds, debt instruments that include a call option on the offeror's stock. The value of these securities reflects the underlying equity, based on the conversion premium--the difference between the price at which the bond may be converted to equity, which is set on the day of issuance, and the current stock price. Because convertibles are structured as debt, they offer downside protection if the stock price falls, and thus have been a haven for investors fleeing the bear market. And because convertibles also provide upside potential from the underlying equity, issuers need pay less interest than they would on traditional bonds to attract buyers.

Recently, demand for convertibles has been so strong that sellers have offered them with no coupon at all. Convertible bond proceeds jumped 50 percent last year, to a record $61 billion; about $15 billion were zero-coupon bonds. So far this year, companies have offered about $50 billion in convertibles, $25 billion of it in zero-coupon notes.

For Arrow, the hungry market meant a $600 million issue of 20-year convertible bonds in February, with a yield of 4 percent and an equity conversion premium of 30 percent above Arrow's share price the day of the offerings. The bond's zero-coupon feature makes the "all-in" premium at the end of the fifth year about 58.5 percent, says Leno, with the expectation that the note will be either converted to equity or refinanced at its first put-call date. "It's really the best of all worlds for the issuer," he says.

Convertible underwriters, predictably, are ecstatic about the surge in activity, and see convertible structures as an increasingly mainstream piece of the corporate balance sheet. "Until last year, most convertible issuers in the [United States] were noninvestment-grade, high-growth companies that saw this as a way to stretch their balance sheet," says E. Philip Jones, head of global equity product development for Merrill Lynch & Co. in New York. "Today, top-tier companies are using convertibles regularly."

Understandably attracted by nearly free money, investment-grade companies such as Tyco International, Enron, The Loews Cos., and The Shaw Group are tapping the market at an unprecedented pace. But the duration of the boom is debatable. While bankers assert that the pricing and volume shifts in the marketplace are permanent, some analysts view these conditions as temporary, and the risks as higher than they seem. Moreover, the cost of selling these bonds may be understated, if only because of their accounting treatment.

The current boom in zero-coupon convertibles owes much to the volatility of the equity market. Even with all other factors constant, increased volatility--when plugged into standard option-pricing models-- boosts the value of the option component of convertible bonds. Issuers with higher stock volatility, particularly high-grade firms with solid credit, can demand premiums of up to 30 percent to 40 percent with no coupon. Yields for these firms have also been shrinking, thanks to interest rate cuts, continued modest inflation, and the "flight to quality" in the credit markets.

Shifts in the pricing of convertibles have convinced executives to take the plunge. "Companies are looking at these premiums compared [with] their growth rates, and figure that there's just a small chance that they will actually convert these issues into equity. With the ability to call the bond in three years, for instance, the trade-off looks pretty good to them," says Jones.

Credit Suisse First Boston upped the ante last spring, increasing the premium on deals for oil and gas services and drilling companies. The first was Anadarko Petroleum Corp., which sold a zero-coupon, 3.50 percent yield convertible with a premium of 40 percent last March. "We had seen a lot of volatility in our stock, so we found that investors were willing to accept a much higher premium than they had in the past," says Anadarko treasurer Albert Richey. Suddenly, the door was open to more aggressively priced deals from higher-grade companies across all industries.


Later in the year, Merrill Lynch underwrote the largest convertible deal ever, a $3.45 billion bond for Tyco International that incorporated a contingent conversion, or "co-co," clause, requiring the stock to surpass the conversion point by 10 percent before actually enabling the switch. The issue, a zero-coupon note with a 1.5 percent yield and 36 percent conversion premium, allows Tyco an accounting bonus as well. Unlike a regular convertible bond, Tyco's note allows the company to exclude the unconverted shares from fully diluted earnings per share, because of the additional barrier to conversion. Other bankers have been quick to imitate this structure.

One issuer was Lennar Corp., which decided on a zero-coupon co-co in early April. "The market conditions were too good to pass up," says Waynewright Malcolm, treasurer of the Miami-based homebuilder. For the bond to convert into equity, Lennar's stock must trade at 120 percent of the conversion price, already a 32 percent premium, in the first five years outstanding. "This instrument gives us debt at a negative spread to Treasuries, and must be deeply in the money before it can convert or be dilutive to EPS," says Malcolm.

Lennar chose the co-co structure largely because of the EPS accounting treatment. "The rating agencies don't give you any equity credit for convertibles, so we see the contingency feature bringing that disparity into line through the accounting rules," says Malcolm.

One potential problem facing issuers is that much of the demand for these bonds is coming from hedge funds that buy derivative instruments based on the convertibles, then sell the company's common stock short for purposes of arbitrage.

That raises the possibility that current shareholders will subsidize the cost of the convertible. Malcolm, for one, dismisses such fears. "That is a short-term effect," he says. Even so, Lennar, like other companies, tried to minimize the effect by doing its convertible deal after the equity markets closed for the day. Despite the move, the stock lost about 6 percent of its value during the following two or three weeks.

Another danger for companies plunging into the convertible market lies down the road. To lower risk for investors, many companies have agreed to allow them to put back their bonds at specified dates. That may not pose a problem if interest rates haven't risen significantly in the interim. But if enough investors put these bonds back after rates have soared, companies that need to raise new capital would find it much more expensive. And that cost could be prohibitive for poor performers.

Despite these concerns, companies are clearly keen on exploiting the convertibles market. Just how long they can do so hinges on both the outlook for a particular company's stock and earnings and on future indicators of volatility. A dip in volatility would cause some immediate pullback in demand, analysts say.

Of course, companies with issues already outstanding, say bankers, welcome such a scenario. After all, with lower volatility, it's less likely their stock will trade past the conversion premium and stay there, and thus more likely they'll be able to call the notes. For intrepid potential issuers, the best advice may be to act before market volatility fades. Others must hope that saner conditions will reopen more traditional avenues to new capital.

Ian Springsteel is a freelance writer based in Boston.


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