Article

Features/Toxic Bonds
Headed For A Fall ; Companies issued special zero-coupon bonds, assuming th=
ey'd never have to pay them off. Now shareholders could be on the hook for =
a $65 billion tab.
Janice Revell

11/26/2001
Fortune Magazine
Time Inc.
131
(Copyright 2001)

It was an irresistible proposition: Borrow billions of dollars, pay no inte=
rest, reap millions in tax breaks, and then wait for the debt to simply dis=
appear. That was the promise of zero-coupon convertible bonds, and companie=
s from Enron to Merrill Lynch binged on what seemed like free money.=20
But, of course, there was a catch: For this scenario to play out, a company=
's stock price had to rise sharply--and quickly. That's because investors b=
ought the bonds in the hope of converting them into equity--if the stock ta=
nked, the bonds would no longer be worth converting. So to make them more a=
ttractive to buyers, companies had to build in an escape hatch: If the stoc=
k price failed to rise sufficiently, investors could "put" (that is, sell) =
the bonds back to the company--in many cases, after just one year.
And that's exactly what's about to happen--to the tune of some $65 billion =
over the next three years. Stock prices have fallen so far that for at leas=
t half of these special hybrids, the prospect of conversion is now absurd. =
It simply won't happen. So bondholders are looking to get their money back =
the first chance they can. And because of the put feature, that is possible=
. Suddenly companies like Tyco, Comcast, and dozens more are on the hook fo=
r billions of dollars in debt and interest they thought they'd never have t=
o pay.=20
That could be very bad news for shareholders of these companies. After all,=
they're the ones who are going to be picking up the tab when all that debt=
comes due. Huge chunks of cash will disappear from balance sheets to repay=
bondholders. Companies without enough cash-- and the majority fall into th=
is camp--are likely to face skyrocketing interest charges when they borrow =
money anew. That means sharply reduced earnings. Especially at risk are inv=
estors in companies with poor credit ratings--prime candidates for killer r=
efinancing costs. Some companies may even be forced to issue stock to pay o=
ff the debt, creating significant shareholder dilution, especially at curre=
nt depressed prices. To make matters worse, this is happening at a time whe=
n the economy is barreling downhill and corporate profits are already shrin=
king. "This is a ticking time bomb," warns Margaret Patel, manager of the P=
ioneer High Yield Bond fund, a top-performing junk fund.=20
The seeds of this mess were sown in mid-2000, when the stock market started=
to falter. Companies in search of capital balked at the thought of selling=
stock while their share prices were struggling. Zero-coupon convertible bo=
nds presented an attractive alternative because companies didn't have to ma=
ke cash interest payments on the bonds (hence the name "zero"). Instead iss=
uers offered an up-front discount--for instance, investors would buy a bond=
for $700 and collect $1,000 when it matured.=20
Companies also gave investors the right to convert the bonds into a fixed n=
umber of common shares. But the bonds were structured so that conversion wo=
uld make sense only if the stock price rose significantly--in many cases, b=
y more than 50%. With that protective feature (called the conversion premiu=
m), zeros took off. Corporate issuers would pay no interest, and once their=
stock prices had climbed back to acceptable levels, the debt would be swep=
t away into equity. "If the bonds are converted, it's a home run for everyb=
ody," says Jonathan Cohen, vice president of convertible-bond analysis at D=
eutsche Bank.=20
That four-bagger, of course, depends entirely on the stock price rising. If=
it doesn't, the bondholders, armed with that handy put feature, can simply=
sell the bonds back to the company. Great for bondholders, but not so hot =
for the company or its shareholders. But, hey, what are the odds of that ha=
ppening? "CFOs and CEOs believe that their stock will just continue to go u=
p," says Cohen. "They don't worry about the bond getting put."=20
If all this seems a little complicated, that's because it is. A real-life e=
xample should help. California-based electric utility Calpine issued $1 bil=
lion in zeros in April to refinance existing debt. At the time, the company=
's stock was trading at about $55 a share--severely undervalued in the opin=
ion of company management. "We really didn't want to sell equity at that po=
int," says Bob Kelly, Calpine's senior vice president of finance. So the co=
mpany instead opted to sell zeros, setting the conversion premium at a heft=
y 37%.=20
Still, with no cash interest payments and a stock price that had to rise si=
gnificantly to make conversion worthwhile, the bonds weren't exactly a scre=
aming buy for investors. So Calpine added the put feature: Investors could =
sell the bonds back to the company after one year at the full purchase pric=
e, eliminating any downside risk.=20
Things haven't exactly worked out as management had hoped. The stock has si=
nce plummeted to $25, and it now has to triple before conversion makes sens=
e. So it's looking as though Calpine will be liable for the $1 billion in b=
orrowed money when investors get the chance to put the bonds this April. Th=
ere's also the refinancing cost. According to Kelly, Calpine's borrowing ra=
te could run in the neighborhood of 8.5%--an extra $85 million per year in =
cash. "Obviously, nobody plans for their stock to go down," Kelly says. "I =
don't think there was one person around who thought the bond would be put."=
=20
Calpine's potential costs are particularly high because its credit rating i=
s straddling junk. "If you are a borderline investment-grade company, a fin=
ancing of this nature is not necessarily the most appropriate thing in the =
world," notes Anand Iyer, head of global convertible research at Morgan Sta=
nley. The problem is, there are a slew of companies with far worse credit r=
atings out there: Jeff Seidel, Credit Suisse First Boston's head of convert=
ible-bond research, estimates that about half of all zeros outstanding fall=
into the junk category. And others are at risk of having their ratings dow=
ngraded before the put date. Today, with junk yielding as much as 5 1/2 per=
centage points above bonds rated investment grade, refinancing can be a pri=
cey proposition.=20
Contract manufacturer Solectron is one that could well get hit by the high =
price of junk. It has $845 million in zeros that it will probably have to b=
uy back this January, and another $4.2 billion coming down the pike over th=
e next couple of years. Because of slower- than-expected sales, the company=
was recently put on negative credit watch by three rating agencies. And if=
Solectron's credit is downgraded, the zeros would slide into junk status, =
a situation that could cost the company--and its shareholders--tens of mill=
ions of dollars in refinancing charges.=20
Refinancing isn't the only worrisome cost associated with these zeros. Comp=
anies pay hefty investment banking fees to sell their bonds--up to 3% of th=
e amount raised. If the debt is sold back, many will have spent millions fo=
r what essentially amounted to a one-year loan. "They're getting bad advice=
," claims one banker who didn't want to be named. "Look at the fee the bank=
er earned and look at the kind of financing risk the company got into."=20
As if those potential consequences were not scary enough, shareholders can =
also get whacked when the bonds are first issued. That's because some 40% a=
re bought by hedge funds, which short the company's stock (sell borrowed sh=
ares with the intention of buying them back at a lower price) at the same t=
ime that they buy the bonds. If the stock goes down, the shorts make money =
from their position. If it goes up, they profit by converting the bond to s=
tock. This hedging strategy almost always causes the stock to plummet, at l=
east for a while. Grocery chain Supervalu, for example, recently lost 10% o=
f its market cap the day it announced it was issuing $185 million in zeros.=
=20
Despite all the pitfalls, the love affair with such Pollyanna bonds continu=
es, thanks in large part to the slick tax and accounting loopholes they pro=
vide. In fact, the hit on earnings per share can be the lowest of any form =
of financing. Even better, thanks to a wrinkle in the tax code, companies c=
an rake in huge tax savings by deducting far more interest than they're act=
ually paying. All they have to do is agree to pay small amounts of interest=
if certain conditions prevail. Verizon Communications, for instance, would=
pay 0.25% annual interest on its $3 billion in zero bonds if its stock pri=
ce falls below 60% of the issue's conversion price. In the eyes of the IRS,=
oddly, that clause enables the company to take a yearly interest deduction=
, for tax purposes, of 7.5%--the same rate it pays on its regular debt. (Wh=
y? Trust us, you don't want to know.) That adds up to an annual deduction o=
f more than $200 million, even if Verizon never shells out a dime in intere=
st. Not surprisingly, more than half of the zeros issued in 2001 contain si=
milar clauses. "It's an incredible deal for them," says Vadim Iosilevich, w=
ho runs a hedge fund at Alexandra Investment Management. "Not only are they=
raising cheap money, they're also doing tax arbitrage."=20
So despite the enormous risks to shareholders, companies continue to issue =
zeros at a steady clip: According to ConvertBond.com, seven new issues, tot=
aling $3.5 billion, have been sold since Oct. 1 alone. "I think the power o=
f the tax advantage is going to keep them around," says CSFB's Seidel. Call=
it greed or just blind optimism that the markets will recover quickly--it =
doesn't really matter. Either way, it's the shareholders who'll be left pay=
ing the bill.=20
FEEDBACK: jrevell@fortunemail.com=20
The bill comes due=20
Companies issued convertible zeros, with put features, when the stock marke=
t soured. Now repayment looms.=20
1999 2000 2001 2002 2003 2004=20
Amount issued, $5.2 $19.6 $37.5 in billions=20
Amount puttable, $2.4 $2.6 $4.8 $22.0 $19.1 $24.0 in billions=20
SOURCE: CONVERTBOND.COM=20
When zero is a negative number=20
The danger posed by convertible zero bonds depends on a number of factors, =
according to Morgan Stanley's ConvertBond.com: the size of the bond, the pu=
t date, the company's credit rating and cash on hand, and how far the stock=
must rise for the bond to convert to equity.=20
[A]Date of put [B]Amount owed (millions) [C]Cash on hand[2](millions) [D]St=
ock price as of 11/09/01 [E]% below conversion price=20
Company Bond rating[1] Our risk assessment [A] [B] [C] [D] [E] Tyco 11/17/0=
1 $3,500 $2,600 $54.00 49% Investment grade Not a problem--for now. The con=
glomerate has cash to pay for bonds put this November. Another $2.3 billion=
is puttable in 2003.=20
Solectron 1/27/02 $845 $2,800 $13.25 155% Investment grade In the danger zo=
ne. May be downgraded to junk if results don't improve. Has additional $4.2=
billion at risk in 2003 and 2004.=20
Calpine 4/30/02 $1,000 $1,242 $25.50 180% Inv. grade/Junk Possibly a pricey=
tab. On the border between investment grade and junk, the energy company f=
aces high refinancing charges.=20
Pride International 1/16/03 $276 $176 $12.50 148% Junk May need to drill fo=
r cash. The oil services company already has a heavy debt load in addition =
to its zeros.=20
Western Digital 2/18/03 $126 $201 $4.25 547% Junk Hard drive ahead. The tec=
h outfit has already paid down some of its zeros by issuing stock. More dil=
ution possible.=20
Brightpoint 3/11/03 $138 $67 $3.25 609% Junk Watch out. This mobile-phone d=
istributor plans to repurchase the bonds and is likely to incur high refina=
ncing charges.=20
Aspect Commun. 8/10/03 $202 $134 $2.00 1,016% Junk The credit rating of thi=
s unprofitable call center company is near the lowest grade of junk. High a=
lert!=20
Enron[3] 2/7/04 $1,331 $1,000 $8.50 1,413% Investment grade Very risky. Amo=
ng Enron's myriad woes, its debt is on the verge of being downgraded yet ag=
ain. It's already behaving like junk.=20
Verizon 5/15/04 $3,270 $3,000 $50.00 70% Investment grade Verizon faces lit=
tle risk because of its strong credit rating and the long lead time on its =
put dates.=20
Merrill Lynch 5/23/04 $2,541 $20,000 $49.00 124% Investment grade Also not =
yet a problem. This underwriting leader made sure its own zeros could not b=
e put for three years.=20
[1]Based on ratings from Moody's and Standard & Poor's; Calpine had a split=
rating at press time. [2]As of most recently reported financial results. [=
3]Now expected to merge with Dynegy.=20
Quote: Contract manufacturer Solectron is one zero-bond issuer that could w=
ell get hit hard. Stocks have fallen so far that for at least half of all b=
onds out there, the prospect of conversion is absurd.

B/W ILLUSTRATION: ILLUSTRATION BY DAVID SUTER=20
Copyright ? 2000 Dow Jones & Company, Inc. All Rights Reserved. =09