Convertible Structures

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Convertible Structures
March 2002
Michael OConnor
Head of International
Convertible Research
+44 20 7545 2361
moc@db.com
Frank Kennedy
+44 20 7545 2361
frank.kennedy@db.com
Clodagh Muldoon
+44 20 7545 2361
clodagh.muldoon@db.com
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March 2002 Convertible Structures
International Convertibles 1
Introduction
The convertibles market has grown significantly since the early days, when
issuance was dominated by US railroad companies, and convertible bonds
are now regarded as a global asset class, with circa $160bn of paper issued
last year. The global capitalisation of the convertible market has reached over
$500bn, despite the difficult equity markets. Continued growth in issuance
leads us to expect that this will continue to increase rapidly over the next few
years.
Innovation has been one of the primary factors in this growth. Convertible
bonds have proved to be a highly efficient and flexible financing vehicle and
as a result, greatly differing features and structures have been developed in
different parts of the world. However, the trend towards increasingly rapid
globalisation has seen the faster adoption of structures from different
international markets. Consequently poorly explained whistles and bells are
continually being added to new bonds, while investors are generally given
less and less time to make investment decisions.
Many features and structures have now become commonplace, without a full
explanation of their effects ever being given. We have attempted to describe
the most common structures that occur within the convertibles market and to
assess their implications for investors, in a bid to answer the most commonly
asked questions. Moreover, as the convertible market is driven by new
issuance, we have attempted to explain the benefits of each of these
structures to issuers, so that investors can assess which features are likely to
be more common going forward.
The convertible market is dynamic, responding, in particular, to tax and
accounting changes, and it would be impossible to cover every idiosyncrasy
in existence. In this review, we have taken a look at some of the more
common structures, how they affect investors and why companies use them.
These structures are not mutually exclusive, but rather operate as a mix-and-
match menu for issuers, and it is often the combination rather than the
individual features that creates the complexity. Hopefully this guide will prove
useful in helping investors understand what issuers are trying to achieve,
especially as innovation and globalisation mean that the pace of change is
likely to remain high.
Convertible Structures March 2002
2 International Convertibles
Contents
Conversion features - macro ........................................................... 3
Conversion features - micro .......................................................... 16
Mandatory structures..................................................................... 30
Zero-coupon bonds and accreting structures .............................. 46
Convertibles and the balance sheet.............................................. 53
Other structures.............................................................................. 65
Conversion features macro
1. Exchangeable bonds
2. OCEANE-style bonds
3. Cross-currency bonds
4. Pre-IPO convertibles
5. Chooser convertibles
Exchangeable bonds
Exchangeable bonds are an established feature of the convertible market,
both from an issuers and an investors perspective, and can simply be
defined as a bond issued by one company which converts into the shares of
another company. The advantages of the structure to the issuer (against an
equity placing) are that the stake is potentially sold for a premium rather than
placed at a discount and that any capital gains liability is at worst delayed
until conversion and may even be avoided entirely.
Vanilla exchangeables are well understood and there is little for investors to
consider apart from the different credit profile compared to convertibles.
However, some convertible bonds issued by subsidiaries (subsidiary
exchangeables) can lead to very different credit exposure for the investor.
Finally, recent accountancy changes will greatly alter exchangeables from the
issuers perspective and may result in significant structural changes to
exchangeables.
One significant difference between convertibles and exchangeables is the
taxation implications for individual investors. In some jurisdictions,
conversion of an exchangeable bond triggers capital gains tax for domestic
investors, while conversion of a convertible does not. For these purposes,
OCEANES and subsidiary convertibles usually count as convertibles.
Investors should be aware of their tax liabilities with regard to conversion of
exchangeables and convertibles.
(Throughout this document, we have followed market convention and used
convertible to mean either the overall asset class (including OCEANES and
exchangeable bonds) or to mean specifically those bonds that are issued by
the company into which they convert. The specific use should be obvious by
context and apologies if this is not the case).
Credit considerations
Exchangeable issuers tend to have far better credits than the underlying
companies into which they convert, particularly in Europe. However, this
need not be the case and, anyhow, it is not the relative difference between
the credit quality of convertible and exchangeable issuers that we think needs
consideration. The key credit difference between a convertible and an
exchangeable, in terms of credit, is that there may well be no or only limited
correlation between the stock price of the underlying shares and the issuers
credit, especially if the issuers stake in the underlying represents only a small
part of its NAV.
This can be positive for investors, in that if the underlying shares perform
poorly, this will not necessarily lead to a deterioration in the issuers credit,
and so the convertibles bond floor will hold, thereby giving the investor
better protection (see Figure 1). In Europe, this is particularly good news for
investors, as the credit quality of exchangeable issuers is almost invariably
high investment grade.
Issuers sell equity
stakes for a premium
while delaying capital
gains tax liability
Stock-credit correlation
is the main difference
between convertibles
and exchangeables
... low correlation is
generally positive given
the high credit quality
of European
exchangeable issuance
Figure 1: Relative credit correlation between a convertible and an exchangeable
Convertible
Telewest 5.25% 2007 GBP
30
50
70
90
110
130
150
170
Oct-99 Dec-99 Feb-00 Apr-00 Jun-00 Aug-00 Oct-00 Dec-00
Bond Price Parity
Strong stock/credit correlation - Telwests
credit spread widens out by 450 bps as
shares plummet
Exchangeable
Fr Tel / Panafon 4.125% 2004 Euro
45
55
65
75
85
95
105
115
125
135
Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01
Bond Price Parity
Weak stock/credit correlation of exchangeable -
despite France Telecom credit widening slightly,
bond floor remains high as underlying share
collapses
Source: Reuters, Deutsche Bank
However, the reverse is also true and an issuers credit can weaken even if
the underlying shares perform well and, in the extreme, where default of the
issuer looks likely, investors may be forced to convert early, possibly even
where the option is out of the money. (Receiving parity of 90% may give a
higher return in a default scenario than payout on the exchangeable as debt).
Indeed, this highlights another problem. Exchangeable bonds are very rarely
secured against the underlying shares and so if the issuer goes into default,
investors will be treated equally to other creditors of the same rank, without
necessarily being given a chance to convert. Thus, for an unsecured
exchangeable with a parity of 150% where the issuer goes into default, the
investor would be treated as an investor with a claim of 150% of the nominal
value. This could be particularly painful for arbitrage investors, as the value of
their short equity position would remain high, while the default payout on the
bond would be substantially lower.
Exchangeable bonds are
rarely secured against
underlying shares
in default, the
investor has an
unsecured claim at the
higher of par and parity
The positive and negative credit aspects of exchangeables probably offset
each other and in the high credit universe of Europe, investors seriously
benefit from this lack of credit/share-price correlation. Nevertheless, investors
should be aware of the differing credit exposure given by exchangeables,
particularly where there are restrictions on conversion, as this can increase
the risks.
Accountancy changes
The structure of exchangeable bonds will always be liable to change in
response to changing tax or accountancy rules. Often, this will be invisible
and irrelevant to the investor, for example, changes to the structure of the
SPV that issues the bonds. However, this is not always the case and investors
should be aware that changes to exchangeable structures may be just as
necessary and important to exchangeable issuers as the CoCo and CoPay
structures have been to convertible issuers.
In particular, investors should be aware of the recent accountancy changes
FAS 133 and IAS 39. In essence, these changes will force companies to
account for their short-option position embedded in the exchangeable
through the P&L account. Clearly, in reality, this would be more than offset by
the underlying equity holding, but these holdings are generally held in
reserve accounts and therefore not run through the P&L. Consequently,
adoption of this accounting practice would increase P&L volatility for
exchangeable issuers, though the real impact and benefit at
conversion/maturity would be the same. In reality, the issuers position has
not changed and they are taking no additional risk! (Note: most major
continental European companies will adopt IAS by 2005 at the latest).
Nevertheless, corporates obviously want to avoid volatility of stated earnings,
even if this could be excluded from normalised earnings. Consequently, we
expect to see some aspects of exchangeable structures alter to avoid the
implications of FAS 133 and IAS 39 and while much of this will be irrelevant
and hidden from investors, there may well be cosmetic changes. However,
we expect these to have minimal, if any impact on valuations.
Subsidiary exchangeables
Many bonds regarded as true convertibles are technically exchangeable, as
the issuing entity is a subsidiary of the company into which the bond
converts. This can happen for several reasons. Firstly, there may be tax,
accountancy or regulatory advantages in issuing through an offshore
financial subsidiary with a guarantee from the parent company. This can be
to the issuers advantage, for example, the old UK convertible capital bond
structure allowed issuers to treat coupons as interest while accounting for the
instruments as equity, effectively creating very tax efficient equity.
Alternatively, it can benefit the investor (possibly passed back to the issuer
through keener pricing). For example, bonds may be issued offshore to avoid
withholding tax. (Indeed, many true exchangeables are also issued from
offshore financial subsidiaries to avoid withholding tax or capital gains, or,
indeed, simply because this is where the underlying shares are held).
Secondly, some companies issue through subsidiaries to take advantage of
better tax and accounting treatment in the subsidiarys tax jurisdiction. For
example, Roche 0% 2021 USD was issued out of the companys on-shore US
subsidiary (Roche Holdings Inc) to take advantage of the tax efficient CoPay
FAS 137 and IAS 39 may
force companies to
account for optionality
through P&L
There may be risks in
mistaking subsidiary
exchangeables for
convertibles, especially
if there is no guarantee
structure (discussed in detail later). There can be restrictions on this and,
specifically, companies are normally restricted from using too much leverage
within foreign subsidiaries, as this would allow earnings to be repatriated
without taxation (these rules are generally known as Thin Capitalisation
regulations.
Some companies issue bonds out of their principal operating subsidiaries as
these have better credit ratings, though conversion rights will still be into the
parent. This structure is not overly common and tends to occur where the
operating subsidiaries are utilities or utility-style businesses with highly
regulated cash flows (often former state businesses that have been
privatised). This can create problems for investors in that while the operating
subsidiary is the better credit, in nearly all cases, this will represent the bulk
of the groups assets and cashflows and, therefore, any default is likely to
stem from this entity. The problem for investors occurs when the subsidiary
goes into default, where there is no guarantee from the parent company. In
this situation, it is entirely possible for the parent company to have separate
assets over which bond investors have no rights. Consequently, the parent
company shares may retain some value, even if bondholders do not get paid
out in full.
OCEANE-style bonds
OCEANEs (Obligations option de Conversion et/ou dchange en Actions
Nouvelles ou Existantes) are a French innovation, allowing issuers to sell
bonds that either convert into new shares or are exchanged for existing
shares, at the issuers choice. This style of bond has no tax or accounting
benefits and, indeed, for these purposes is treated as a convertible. The real
advantage of the structure for the issuer is the extra balance-sheet flexibility it
provides, as it allows the issuer to deliver either Treasury shares or new
shares on conversion.
OCEANEs give the issuer great flexibility with their balance sheet. The ability
to deliver existing shares creates a great route for the disposal of Treasury
shares, while if these are needed for other corporate purposes, conversion
can be met through the issue of new capital. Finally, the use of a cash-out
option means that the Treasury shares can be cancelled if the company is
over-capitalised at the time of conversion. The flexibility afforded by
OCEANEs allows French issuing companies to actively manage their balance
sheets, making this a very popular (and common) structure in France.
From the investors perspective, the key impact is on dividend entitlement. In
France, new shares may have different dividend entitlements to old shares
and so investors may be affected by whether new or old shares are delivered.
Old shares are entitled to dividends with respect to the XD date. New shares
are entitled to dividends for the financial year of conversion and beyond.
This is best explained using an example: ABC SA has a financial year ending
on 31 December and pays an annual dividend that goes XD on 1 April. If a
holder of an OCEANE converts after 1 April in any year, there will be no
difference between old and new shares and both will rank for the following
years dividend. If a holder converts before 1 April, then old and new shares
would be treated differently. Old shares would rank for the next dividend,
while new shares would receive their first dividend the following year.
Figure 2: Different implications of the outcomes of converting an OCEANE bond
Bondholder
Converts
bond
Issuer has
balance
sheet
flexibility,
can decide
to either:
A:Deliver
existing shares
B: Deliver new
shares
Dividend: Entitlement begins
from financial year of
conversion and beyond
Dividend treatment: entitled
to dividend from the ex-
date
Source: Deutsche Bank
Issuer has option to
deliver new OR existing
shares upon conversion,
giving issuer balance-
sheet flexibility
Key difference between
new or old shares is the
investors entitlement
to dividends
Despite the complexity with regard to dividend entitlement, investors are no
worse off than if the company had sold a vanilla convertible (a French vanilla
convertible issue would give the worst-case dividend entitlement of an
OCEANE). OCEANEs are now a very well established investment vehicle and,
indeed, have almost become the standard within the French domestic market,
though the structure does not appear outside France.
Cross-currency bonds
Cross currency convertibles are those in which the bond is denominated in a
different currency from that of the underlying stock. This means that
investors have currency exposure on the option portion of the convertible,
because this will be affected by the exchange rate.
Parity = (stock price x conversion ratio) / FX in local currency
This formula means that if the currency of the underlying stock weakens,
parity will fall, even if the stock price remains unchanged. However, there
may well be some offsetting correlation between the stock price and the
exchange rate. This can be for operational business reasons (for example,
where the majority of the companys profits are earned in the currency of the
bond rather than the currency of the shares) or for valuation reasons (for
example, in an industry where companies tend to be valued against
international peers).
Consequently, when modelling cross-currency convertibles, investors need to
adjust the volatility of the underlying share by its correlation with exchange
rate movements. Alternatively, investors can calculate the stocks volatility in
the currency of the bond and this will take any correlation into account. This
value is then used in the binomial model as the volatility assumption for the
cross-currency convertible. Using volatility in the currency of the bond strips
away most of the complexity of valuing cross-currency convertibles.
However, when pricing cross-currency new issues, investors should
remember to use the OTC volatility of the underlying in the currency of the
bond. When there is no OTC options market in the underlying, investors
should use the long-dated historic volatility of the underlying as a guide, but
again in the currency of the bond. Failing to use the volatility in the right
currency can seriously affect the accuracy of the new issue valuation.
Accurately modelling
cross-currency bonds
requires correlation
analysis between
underlying share and
exchange rate
Pre-IPO convertibles
The last few years have seen several companies issue bonds that give some
form of optionality in the event that an IPO or a corporate listing occurs.
Clearly this optionality is completely dependent upon whether the issuer
proceeds with the IPO and, consequently, the value that the market ascribes
is somewhat limited and these issues tend to be very bond orientated. The
principal reason why companies sell these issues is to signal to the market
that an IPO is planned and highly likely, increasing interest and coverage
(while at the same time raising at least as much as could be achieved through
a straight bond issue).
In this research, we have looked at three different pre-IPO structures, which
give very different investment profiles and which have very different potential
impacts on the IPOs themselves. Firstly, we have considered the CORE
structure, which, in essence, is a straight bond that becomes a convertible if
the IPO occurs. Secondly, we have considered the Vivendi (Environment)
1.5% 2005 Euro, which contained an option to convert into Vivendi
Environment shares at the IPO. Finally, we have looked at the KDIC pre-IPO
convertible, which has a similar structure to the CORE bonds, but with a
different reference price for the conversion ratio.
CORE bonds Convertible On Reference Event
Figure 3: Structure of a CORE
CORE
Bond
Trigger event
does not occur
Trigger event
occurs
Bond redeemed at an
enhanced level
Investors put bond at
issue price
Investors receive pre-
defined convertible
CORE bonds conditionally become convertible, dependent upon whether or
not a specified event occurs. Usually, but not exclusively, this event is an IPO,
though it could potentially be a share sale or completion of an acquisition or
similar event. If the triggering event does not occur within a specified
timeframe, the bond is simply redeemed at favourable terms for the investor,
giving a bonus yield above the issuers straight debt. However, if the event
does occur, the bond will become convertible on pre-defined terms. Investors
also have the option to put the bond back to the issuer at the issue price,
Several different
structures give some
form of optionality over
an IPO
CORE structure returns
an enhanced straight
debt return in the
worst-case scenario
should they decide they do not want the convertible at the time of the
triggering event, protecting them against changing market conditions.
The bond can be thought of as a conditional forward on a pre-defined
convertible bond. In fact, allowing for the put, the bond is a conditional
European-style option on a forward on a pre-defined convertible bond. While
the issue in itself can be taken as an indication of the intent of the issuer,
there is still a degree of uncertainty regarding the triggering event. This
uncertainty is offset by a higher expected return to investors whether the
reference event occurs or not, as the investors either holds a bond with an
enhanced yield (which is therefore worth more than the issue price) or a
convertible which has even greater value.
How to value the CORE structure
Working out a true theoretical value is problematic, as it is impossible to
quantify the chance of the triggering event occurring and therefore it is not
possible to assign objective probabilities as to whether investors receive the
convertible or the redemption proceeds. Working out the minimum value of
the issue is far easier this is simply the lower of the two possible outcomes
(ie, the forward on the convertible or the cashflows received if the triggering
event does not occur). As the clear intention/expectation of the issuer is that
the triggering event will occur, investors are far more likely to receive the
(higher valued) convertible than the straight bond.
Valuing the forward convertible presents some difficulties. Convertible
valuations tend to be versed in terms of implied volatility rather than
theoretical value, but this forward structure has cashflows attached up until
the triggering event and there may also be an element of premium
redemption attached to the yield if the triggering event does not occur.
Investors should use the redemption price if the reference event does not
occur as the issue price of the convertible if they wish to calculate its
forward implied volatility.
In terms of the other assumptions, investors should use the relevant forward
portion of the yield curve and the forecast for dividends based after the last
possible date for the reference event. Investors are effectively getting the
enhanced yield and then, if the reference event occurs, are receiving a
convertible at this implied.
Alternatively, investors can use conservative assumptions to calculate a
theoretical value for the convertible at the potential IPO date and then use this
theoretical value as the redemption price, together with any coupons
received, to work out the potential yield of the core bond from issue to the
IPO date.
How is the premium calculated?
If the IPO price is used as the reference price for the premium, hedging of
convertible positions could then put the IPO under pressure, either before
launch in the grey market or immediately after the IPO. To alleviate this
problem, the reference price for the CORE bonds is based on an average
market price after the triggering event. The actual price used to calculate this
average will depend upon where the underlying is listed, but could be the
closing auction or the opening price or VWAP. The number of days in the
averaging period will depend on the liquidity of the underlying. Using this
Investor uncertainty
offset by higher
expected return
Difficulty in estimating
probability of QPO
creates problems in
calculating theoretical
value
Investors can use the
theoretical value to
calculate the CORE
bonds yield to IPO
averaging period to calculate the reference price for the convertible should
minimise the impact on the IPO and will help to maintain an orderly after-
market.
Vivendi Environment
An earlier example of a pre-IPO was the bond sold by Vivendi Environment
(at the time a wholly owned subsidiary of Vivendi), which was guaranteed by
Vivendi and converted into shares of Vivendi (either new or existing).
Investors also had the opportunity to convert into shares of Vivendi
Environment if and at the time an IPO occurred, effectively at a discount to
the IPO price. This is a significantly different structure to the CORE bonds, as
investors end up with shares at the IPO, rather than a convertible.
Indeed, the Vivendi Environment IPO did occur and a substantial proportion
of bondholders did convert into the new company. The mechanics of this
conversion was that the market price of the convertible bond was increased
by 5% and this was then converted into Vivendi Environment at the IPO price.
Because of the relative size of the IPO and the market capitalisation of the
convertible at the time, bondholders participation was limited to
approximately 50% of their bonds. The rump of the bonds still trade and
remain convertible into Vivendi.
One of the key advantages of the Vivendi Environment structure from an
investors perspective is that investors get exposure to the new company
from the IPO price. In other words, investors are buying conditional delta,
whereas with a CORE bond, investors are buying conditional volatility (the
reference price is struck as an average over a trading period after the IPO).
However, this advantage for the investor is a serious disadvantage for the
company, in that a Vivendi Environment-style structure allows arbitrage
accounts to attack the IPO price by holding a long-bond position and short-
selling the IPO shares ahead of this to capture the discount offered through
the convertible. Indeed, the Vivendi Environment IPO took place under
difficult market conditions and the pre-IPO shorting caused by this convertible
structure contributed to the IPO price range being lowered twice and nearly
caused the whole offering to be postponed.
KDIC
The Korean issuer KDIC sold a pre-IPO convertible in 2001 that was
something of a cross between the Vivendi Environment and the CORE
structure. Like the CORE bonds, there is no conversion unless an IPO occurs
and after a qualifying IPO, the bond becomes a convertible. However, unlike
CORE-style bonds, the reference price is the IPO, giving investors immediate
exposure to the shares following the IPO, but also potentially leading to short
selling ahead of the share offering.
A significantly different
structure, as investors
end up with shares at
the IPO
Pricing mechanism had
a strong detrimental
impact on the IPO
Chooser convertibles
Chooser convertibles are a relatively recent and rarely used innovation, but in
essence are simply bonds with a `best of option into a number of different
underlying equities. The first of these issues - the Swiss Re triple - gave
investors the right to convert into shares of Swiss Re itself, or into shares of
either Credit Swiss or Novartis at the investors choice. This structure
obviously gives greater value to investors than a vanilla Swiss Re convertible
(with all other terms being equal) or, indeed, an exchangeable into either of
the two other stocks. Indeed, some outright accounts have viewed this bond
as an excellent play on the Swiss market, on the grounds that at least one of
the underlying stocks would outperform the index.
Figure 4: Swiss Re Triple Parity is the best of the three component parts of the exchange property
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
Feb-00 Apr-00 Jun-00 Aug-00 Oct-00 Dec-00 Feb-01 Apr-01 Jun-01 Aug-01 Oct-01 Dec-01
Swiss Re CS Shares Novartis Parity
Credit Suisse
shares form
parity
Novartis
shares form
parity
Swiss Re
shares form
parity
Whilst diversification of best-of option
reduces downside exposure, it also reduces
the volatility of the option value
Source: Bloomberg, Deutsche Bank,
However, because at the time the bond is sold it is impossible for investors to
know which particular underlying share (if any) will provide the optimal
conversion, this instrument is not popular with stock-picking outright
investors and these investors never seem to fully appreciate the value of the
additional optionality.
Indeed, part of this relates to problems with modelling chooser convertibles.
Chooser options themselves are well-understood exotic options, but are
usually European exercise and therefore modelled as such. Chooser
convertibles need to be modelled as American options and have far greater
path dependency and, unfortunately, few convertible models have this type
of chooser functionality built in. Consequently, few investors are able to
accurately evaluate these bonds, which affects the market price even for
those that can. As only a small number of chooser bonds have been issued,
many investors have not developed the required additional functionality
within their models, but simply allow a small amount of additional implied
volatility to allow for the enhanced optionality.
Structure gives greater
value than a vanilla
convertible
Greater path
dependency in the
calculation of American-
style chooser options
makes them difficult to
model when embedded
within a convertible
bond
From the companys perspective, the advantages of selling a chooser option
simply boil down to opportunity and pricing. For an issuer with relatively
large stakes in a number of different companies, which is happy to sell part of
any of these stakes, issuing a chooser effectively has minimal cost, as the
issuer is indifferent as to which stock the investor converts into. However,
even though many participants in the market do not fully evaluate the
enhanced optionality, investors do recognise that there is additional value
and this allows tighter terms and, therefore, cheaper financing, even though
they probably do not fully account for the value of the chooser option.
Chooser convertibles have the same accounting treatment as exchangeables
and under US GAAP, the bond will be bifurcated (ie, split into bond and
option components), with the option component then marked to market
through the issuers P&L. However, depending on the correlation of the
underlying shares, a chooser option may have lower volatility than a single
stock option, reducing the volatility of the bonds P&L impact.
A refinement on the chooser convertible is the addition of the parity switch,
which gives the issuer greater flexibility in which underlying is delivered. This
feature allows the issuer to deliver the underlying of its choice but with a
market value equal to the value of the shares the investor wishes to convert
into, with an additional premium paid to the investor for the inconvenience of
not getting the stock of their choice. The mechanism for determining the
market value of the two stocks involves an averaging period, so that investors
can fully hedge their position. (Telecom Italia OPERA notes are a good
example of this).
Lower option volatility
will reduce the volatility
of the P&L impact
Conversion features - micro
1. CoCo
2. Cash-out options
3. Resets
4. Make-whole
5. Takeover protection
CoCo bonds
Contingent Conversion (CoCo) features are an accounting innovation
developed to minimise the dilutive impact of convertibles under US GAAP,
introduced in the US in late 2000. Basically, conversion is only possible under
certain specified circumstances, most commonly related to the share price.
While these are not satisfied, the company need not account for the dilution
associated with conversion. CoCo issuers have tended to be high credit
quality companies focused on limiting dilution. Maturity has tended to be
long (most commonly 20 years), but these issues have had relatively low
initial deltas (particularly for US issues), with high bond floors maintained by
rolling puts (CoCo features have commonly appeared in bonds that also
contain CoPay and Lyon features).
Figure 5: Convertibility of CoCo bonds for movements in parity
70
80
90
100
110
120
130
140
150
May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02
P
a
r
i
t
y
20 trading day average share
price falls below 115% of
conversion price - bonds
NOT convertible
20 trading day average
back above 115% - bonds
become convertible again
20 trading day
average share
price above 115%
trigger - bonds
are convertible
Source: Reuters, Deutsche Bank
The restriction on conversion with these bonds is related to the share price
and is generally expressed in terms of parity. A fairly standard example
would be to only allow conversion if the share price exceeded 110% of the
conversion price, though this can be complicated if the bond is also a
LYON/OID (where the conversion price will rise at the accretion rate). Also,
some CoCo bonds have a sliding conversion hurdle, generally starting at
120% of the conversion price, falling to 110% over the life of the bond.
Restrictive conditions
upon conversion rights
allow CoCo issuers to
avoid immediate
dilutive impact of
convertible issuance
Figure 6: Trigger levels of US CoCo deals in 2001
0
5
10
15
20
25
110% 120% 125% 135%
Trigger
N
o
.

o
f

d
e
a
l
s
Source: Reuters, Bloomberg, Deutsche Bank
Clearly, investors need to be protected against calls or corporate actions that
could be used to take away all of the optionality in the bond (ie, if the bond
were called while conversion was restricted, investors would be unable to
convert, even if parity were above 100% of the conversion price).
Consequently, the contingent restriction on conversion is lifted in certain
circumstances. Specifically, the bonds will become convertible under most
M&A scenarios, or if any qualifying capital distributions are made, and
conversion is also allowable if the bonds are called for early redemption.
These standard protection features give significant comfort to investors and
remove some of the foreseeable additional event risks of the CoCo structure,
but often the trigger levels for special dividends, for example, remain high
and therefore a significant risk. Investors should also be wary of the need to
convert a bond in order to participate in an unforeseen (and therefore
uncovered) corporate action.
Even assuming the event risks are fully covered, this structure still has
valuation implications for investors. The graph below gives the payout at
maturity of a bond with a 110% CoCo feature. The lost optionality between
parity of 100% and 110% could be repurchased within the OTC market,
potentially allowing easier valuations, though liquidity may make this
impractical and expensive, especially as CoCo bonds tend to be very long.
Lost optionality can
theoretically be
replicated in the OTC
market, but this may
not be practical
Figure 7: Pay-off profile of CoCo bonds versus standard convertible
Equity
Issue price
Lost optionality
due to CoCo
structure
Share price
Conversion
price
CoCo Trigger
T
o
t
a
l

r
e
t
u
r
n
Standard
Convertible
High gamma
around CoCo
trigger level
A long call option with a strike equal to parity of 100% and short call with
strike equal to parity of 110% neatly replaces the lost optionality of the dead
zone. However, as a hedge to normalise the convertible, even this is
imperfect, as it still leave investors with an additional return (10 points) if
parity finishes above 110%. The best way to correctly and fully model CoCo
bonds is to build the feature into convertible tree-based (eg, binomial) or grid-
based (eg finite difference) models in a similar manner to soft calls. However,
many investors have yet to update their models to allow for CoCo features,
and as a general rule of thumb, the market assumes CoCos are worth one or
two implied volatility points off the value of the convertible.
There is an additional concern with CoCos, though this problem is unlikely to
emerge in the near term with existing issues due to the long maturities of
current CoCo bonds. Hedging CoCos approaching maturity would be
exceptionally difficult if parity were in the dead zone, as the delta of the bond
would fluctuate wildly, depending on whether the bonds conversion features
where activated or not. This problem may be exacerbated by the exact
mechanism of the stock trigger (whether it was a rolling 20 consecutive days,
20 out of 30 trading days, etc) and while this high gamma is not negative, it
certainly creates significant risks for arbitrage investors.
This is not as much of a problem at the put dates, as it is hard to visualise a
realistic scenario under which investors would put the bonds were parity in
Bonds near CoCo
trigger will have
substantial gamma as
maturity approaches
the dead zone (without a corporate action), as the option value should be
greater than the put price. Indeed, this problem is unlikely to occur at all with
existing issues due to the high number of puts and calls before maturity, but
future deals may have shorter maturities, or fewer early redemption features
(particularly if the structure is adapted for European issues).
The greatest risk to investors and, in particular, arbitrage investors with
regard to CoCo bonds concerns their treatment by prime brokers. Unless the
contingency features have been triggered, the bonds are non-convertible and
therefore an arbitrageurs long-bond position does not match their short-
stock position, in that they cannot necessarily convert to meet their short-
stock position. Currently, prime brokers are not accounting for this mismatch
risk with CoCo bonds when calculating margin requirements from and
leverage available to convertible arbitrage investors. However, this mismatch
does exist and any change in attitude from prime brokers would be likely to
have a significant impact on the basis of CoCo bonds.
CoCo bonds certainly take value away from investors, but the accounting
benefits to issuers mean that without changes to accounting principles, this
feature is likely to remain commonplace. Indeed, while we do not believe the
accounting treatment under US GAAP is universal, preliminary inquiries
suggest other accounting regimes give similar treatment and investors in
international convertibles (and in particular in Europe) should become
familiar with this structure.
One final and often ignored consideration is that issuers may have greatly
increased volatility of stated diluted EPS if the share price fluctuates around
the CoCo trigger. As we have seen with chooser convertibles, this is
something that issuers often seek to avoid, though so far, this has not
diminished CoCo issuance.
Valuation of CoCo
bonds at risk from
potential changes in
Prime Brokerage
accounting
CoCos may lead to
increased EPS volatility
Cash-out options
Cash-out options are now almost universally included in exchangeable bonds
and are becoming far more common, even in convertibles. This feature gives
issuers the ability to deliver the cash value of the underlying securities on
conversion and thereby greatly enhances the flexibility from the issuers
perspective. With an exchangeable, this means that the issuer need not
physically hold the shares for delivery, but can hedge out their exposure with
derivative transactions or, indeed, if the shareholding has increased in
importance, the issuer need not deliver shares that they wish to retain. From
the perspective of a convertible issuer, a cash-out option will give the
company much of the additional balance-sheet flexibility of an OCEANE,
preventing equity from being issued if the company is overcapitalised.
From the investors perspective, the existence of a cash-out option does not
in itself affect the valuation. What does make a difference is how the cash
value of the underlying securities is calculated and specifically whether there
is a look-back option for the issuer. The cash value of the underlying
securities will be determined over an averaging period. If the issuer knows
the value from this averaging period (ie, if they can look back) before they
decide whether to give the investor cash or shares, they have the opportunity
to deliver whichever has the lowest value. This optionality for the issuer
clearly takes value away from the investor.
Extracts from US Cellular 0% 2015 USD bond prospectus:
In lieu of the delivery of Common Shares upon notice of conversion of any
LYON, the company may elect to pay the Holder surrendering a LYON an
amount in cash equal to the Sale Price of a Common Share on the Trading
Day immediately prior to the Conversion Date multiplied by the Conversion
Rate
the Company shall inform the Holder through the Conversion Agent, no
later than two business days following the Conversion Date, (I) of its election
of the delivery of Common Shares or to pay cash in lieu of delivery of such
shares
If the Company elects the delivery of Common Shares, such shares will be
delivered through the Conversion Agent as soon as practicable following the
conversion date. If the Company elects to pay cash, such cash payment will
be made to the Holder surrendering such LYON no later than the fifth
business day following such Conversion Date.
The Sale Price on any Trading Day means the closing sale price per share
for the Common Shares
Source: US Cellular 0% 2015 USD Bond Prospectus
Look-back options are very common in US issues and, indeed, investors
should expect US issuers to extract the maximum value from these clauses.
In Europe, cash-out options are seen as creating flexibility for issuers rather
than necessarily creating value and even where the issuer has a look-back
option, many will tell investors of their intentions in advance. Indeed, later
issues in Europe have removed the look-back from cash-out options,
An increasingly
prevalent clause that
gives the issuer the
option to deliver the
cash value of shares
upon conversion
Primary concerns are
the timing mechanics of
the decision and the
method of calculating
the cash value of
conversion
requiring issuers to inform trustees (and therefore investors) of their
intentions regarding the cash-out option in advance.
It is also possible that an issue can actually give a look-back option to the
investor. This happens when the issuer is obliged to inform the investor in
advance of whether they intend to give cash or shares and where the
averaging period is prior to the conversion date. This can effectively give a
look-back put option to investors if the company chooses to deliver cash.
Figure 8: Characteristics of cash-out option and look-back option on US Cellular 0% 2015 USD
Conversion date
The date on which the bondholder
gives notice of their intention to
convert bonds
Cash reference date
Closing share price used to
reference cash amount
Decision date
Date at which company
has to inform investors of
election to pay cash in
lieu of shares
Cash payment date
The date on which the bondholder
receives the cash payment if the
company have made the election to
do so
Duration of
investors short
call position
Source: Bond prospectus, Deutsche Bank estimates
Rare examples exist
where the investor has
the benefit of a look-
back option
Resets
One of the most interesting developments in the convertible market in the
mid-1990s was the introduction of reset' clauses. Reset clauses (often called
parity resets) mean that on certain dates, the conversion price is reset to a
level at (or near) the prevailing share price (ie, if the shares fall, you get more
of them per bond to make up for the fact that they are worth less). In theory,
resets can be upwards or downwards, but so far, all bonds containing resets
have allowed downward-only adjustments to the conversion price ie, all
current resets can only create value for investors. There is always a maximum
limit on the adjustment, which means that the conversion price can be
adjusted down to a certain minimum, often 80% of the initial conversion price
at issue.
This feature is most frequently found in Japanese and Asian (especially
Taiwanese) convertibles. In Japan, resets are often attached to mandatory
issues, which have unique characteristics and are discussed more fully in the
section on mandatory securities. The Taiwanese issues have often come from
technology-based growth companies, which have been keen to see their
convertibles swapped into equity and have particularly wished to avoid cash
outflows from redemption. By attaching resets to their convertible bonds,
these companies have increased the probability of conversion, while still
allowing issues to have healthy initial premiums. This has proved particularly
popular in Taiwan, where resets have been used to partially offset the
disadvantages investors face through lack of stock borrow and the long
conversion process.
Figure 9: Parity reset convertible bond payoff
Equity
Issue price
Parity reset
level
Share price
Lower stock
price reset
level
Initial conversion
price
T
o
t
a
l

r
e
t
u
r
n
On certain dates, the
conversion price may be
adjusted (invariably
only downwards) to a
maximum limit
Reset features
historically most
prevalent in the
Japanese and
Taiwanese markets
In the last couple of years, resets have started to appear in a few European
deals, sold by smaller issuers. The payoff graph demonstrates that the reset
provides support for lower credit quality issuers, or issuers where the credit
correlates strongly with the share price, effectively replacing the bond floor.
Indeed, the diagram above, showing payoff for a parity-reset convertible,
demonstrates that for a high credit quality issuer, this feature will essentially
create an additional second bond floor. This feature has only appeared in a
small number of European deals, but nevertheless, we believe it may increase
in frequency amongst smaller issuers.
Obviously, reset bonds greatly increase the path dependency of the bonds
optionality and consequently increase the difficulties in modelling these
bonds. Early evaluations used Monte Carlo simulations (see Convertible
Securities: An Investors Guide, page 73 for an example of how this is done),
but in reality, the feature needs to be built into a tree-based or (preferably) a
finite difference model to calculate accurate values and Greeks. Once again,
the difficulties in modelling the feature means that its value to investors is
generally underestimated, creating opportunities for investors who fully get
to grips with the feature.
Figure 10: Gamma characteristics of reset bonds
0%
20%
40%
60%
80%
100%
120%
140%
1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201
Parity
D
e
l
t
a
Normal Reset Mandatory reset
Reset bonds typically display an inverse
correlation between stock price and parity
around the reset level - this is negative
gamma which is bad news for
arbitrageurs as rehedging involves buying
shares high and selling them low
One of the problems for arbitrage accounts trading reset bonds is that
negative gamma situations can arise. This is because if the shares are
trading in the reset zone, it will seem probable that the conversion ratio will
rise on the reset date and, consequently, the theoretical delta may increase as
the share price falls. In this situation, an arbitrageur wishing to remain delta
neutral will be forced to sell as the share price falls and then buy them back if
Accurate valuation and
derivation of Greeks
best achieved via finite
difference model
Negative gamma can
catch out convertible
arbitrage investors
the shares were to recover. Consequently, volatility in this reset zone of
negative gamma can cause the arbitrage investor to make substantial losses.
This problem is far lower with a reset bond than a reset mandatory (see the
section on mandatory securities), as the bond floor itself will act like a put
option on the shares, giving some positive gamma in the reset zone and
partially offsetting the effect of the reset. Indeed, positive gamma will pick up
strongly if the share price falls below the reset zone. However, this is only
true where the credit is strong and where there is minimal credit correlation
with the stock price. When the issuer is a weaker credit, the delta profile will
be closer to that of a mandatory reset.
Make-whole
Make-whole features are a relatively common and well-understood feature of
the US market and were particularly prevalent in the technology boom of
1999 and early 2000. Elsewhere, these features are very rare and poorly
understood. Make-wholes have generally been used as a supplement to early
provisional calls, effectively protecting the investors income advantage over
the shares and increasing the suitability of the issue for equity and income-
based investors.
The issuer benefits because if the shares perform, the company will be able
to force conversion earlier, thereby strengthening the balance sheet. Clearly,
this feature is best suited to second-line credits among growth stocks and this
explains why it featured so frequently among US high-tech issuance.
Make-wholes fall into two categories - premium make-wholes and coupon
make-wholes. Premium make-wholes are designed to appeal to those
investors that look at breakeven (the time it takes for a convertibles coupons
to pay back the premium), while allowing the issuer to force conversion if the
share price performs. With premium make-wholes, the investor recovers the
original premium paid at issue, less the value of any coupons received if the
provisional call is activated. There is some variance between issues and the
exact conditions will be spelled out in the individual documentation.
Coupon make-wholes work in a slightly different way. Here, the investor
receives the unpaid coupons from the provisional call period, ie, the investor
is guaranteed to receive all interest up to the first hard call date, even if a
provisional call is exercised prior to this date. Again, there are some
variations in how the make-whole is applied and investors need to check the
documentation. In particular, some make-wholes pay the full value of any
remaining coupons, while others only pay the discounted NPV of the
remaining coupons.
The early redemption of the bond remains optional, as the company may
decide that forcing conversion is not economic, particularly with a premium
make-whole, where the make-whole payment could be significantly greater
than the coupons remaining before provisional call protection expires. Also,
no company wants a potentially large cash liability arising at a time out of
their control, as could happen if the provisional calls became mandatory!
For the sake of clarity, it is worth pointing out that investors receive the make-
whole payment if they convert following a soft call, but not if their bonds are
redeemed. This effectively reduces the likelihood of the company being
forced to redeem following a call, even if the shares plunge, as parity would
have to fall below the redemption value by more than the make-whole
payment before it would be economic to redeem rather than convert.
Traditionally, make-wholes have been used with high soft-call triggers and
there has been minimal risk that a company would be required to redeem the
bond after exercising the soft call. However, as we have discussed, the make-
whole payment only applies after conversion. Indeed, if the make-whole
payment were only given to holders who converted immediately following
the call notice, the risk of the issuer being forced to redeem the bonds would
fall even further. This may allow even highly volatile companies to use
provisional calls without running the risk of being forced to redeem the
bonds, possibly even with lower trigger levels.
The predominantly US
feature protects
outright investors from
early calls
Make-wholes are either
premium or coupon
based
Payment only effective
upon conversion and
not upon redemption
The relative value of premium versus the coupon make-wholes to the
investor is dependent upon the level of the initial premium and the size of the
coupons. Obviously, with low premium and high-coupon bonds, coupon
make-wholes will be more valuable, and vice versa. As better credit quality
companies will be able to achieve issues with higher premiums and lower
coupons, the relative merits of these two structures are somewhat dependant
upon the actual credit of the issuer.
In terms of valuing make-wholes, the feature is included in many convertible
models. However, as issuers who include this feature tend to be below
investment grade, there is likely to be strong credit correlation with the share
price, which can complicate the valuation. We have ignored this credit
correlation to demonstrate the valuation impact of make wholes.
Figure 11: Premium protection from make-whole provisions
105
110
115
120
125
130
135
140
100 105 110 115 120 125
Parity
T
h
e
o
r
e
t
i
c
a
l

v
a
l
u
e
No call & no Make Whole Callable & no Make Whole
Callable & premium Make
Wh l
Callable & coupon Make
Wh l
Coupon and premium make
whole provisions mitgate the
valuation impact of callability
Merits of the two
structures dependent
upon the credit quality
of the issuer
Takeover protection
Takeovers remain the biggest area of event risk concern within the
convertible market. When the conversion/exchange property (ie, the
underlying equity) is acquired or merged with another entity, the overriding
concern for convertible holders will be what the conversion rights change to
and whether they will retain any optionality. In most takeovers, the target
company continues to legally exist as a (subsidiary) stock corporation of the
acquirer and in many jurisdictions, there will be no automatic right of
ongoing conversion into the dominant company. In this case, unless there are
specific structures protecting the investors, or unless the acquirer voluntarily
makes a more generous offer, bondholders are forced to either convert or
retain the bond without any conversion rights. (In truth, the bond would still
be convertible into the unquoted and wholly owned subsidiary and
consequently, the conversion rights are valueless).
Figure 12: What happens in a takeover?
Of limited
concern, value
of bonds
adjust to
volatility of
new
underlying
shares
Is there a
reinvestment
clause?
Lost optionality due
to zero volatility of
cash component
YES
NO YES
Value of optionality
dependent upon
reinvestment
property
Convert Retain bonds
without
optionality
NO
Both clauses only apply for
a specified time period,
usually 60 days
Enhanced
conversion
window - 2
main types
Average
premium
enhancement
Stepped
conversion (or
ratchet) clause
NO YES
YES
Are there specific structures
protecting bondholders?
Has the acquirer
made a more
generous offer?
NO
Issuer receives offer proceeds in lieu of
their shareholding which traditionally
becomes new exchange property
NO
Does the deal include
cash?
Is the bond an exchangeable?
Takeover event
A series of structures have been developed to protect investors under
change-of-control scenarios, though in some countries, there is also some
element of statutory protection; for example, in France, it is usual for an
acquirer to allow continued conversion into the acquired shares. Change of
control structures fall into two categories, protection for convertibles and
protection for exchangeables. Protection for convertibles generally takes the
form of an increase in the conversion ratio, applicable for a short period after
the takeover offer goes unconditional generally referred to as an enhanced
conversion window.
Largest area of event
risk in convertible
market - each situation
must be rigorously
analysed on a case-by-
case basis
There are two main conventions for enhanced conversion windows. The first
is stepped conversion (or ratchet) clauses. Here, the enhanced conversion
ratio that is applicable is determined according to a schedule set out in the
bonds prospectus. This will generally fall as time goes by from the issue date
to the first hard call. On the announcement of a change of control, convertible
holders will have a window of usually 60 days to convert at the prevailing
enhanced ratio. The second type of protection for convertibles is average
premium enhancement. Here, the clause states that under a change of
control, the conversion ratio is enhanced according to the average premium
of the bond over a given time period (normally the 12-month period ending
the month before the last complete calendar month). Again, the enhanced
conversion window only applies for a specified time period, normally 60 days.
With exchangeables, the situation is somewhat different. The issuer may not
own any additional shares of the underlying and so may not be able to give
an enhanced conversion window. Even if they did, they certainly would not
want to commit to delivering these extra shares in a takeover, as this would
restrict their flexibility. However, the issuer will receive the proceeds of the
takeover offer in lieu of their shareholding underlying the convertible and
traditionally this has become the new exchange property. Where the offer is
entirely for shares, there is no problem, but in the event of a cash takeover, all
optionality may be lost (cash has no volatility) and where there is a partial
cash element, optionality will be diluted. Also, when cash does remain in the
exchange property, the key factor is whether or not this is reinvested for the
benefit of the investor or whether the issuer receives the interest.
In recent exchangeables, protection has been included to prevent cash
dilution of optionality in the event of takeovers. This has taken two forms:
continued optionality and cash compensation. Continued optionality is the
more common form and the structure developed for the Munich Re/Allianz
exchangeable is the most comprehensive. Here, the issuer has agreed to
reinvest any cash proceeds from a takeover in other equity securities in the
exchange property or in shares of the acquirer, or if neither of these is
applicable, in an equity index (the DAX in this case). This essentially
guarantees the investor optionality over the life of the bond.
The alternative form of protection gives compensation for any cash element
in an accepted offer - Allianz/Siemens 2% Euro 2005 is a good example. Here
again, there is continued conversion in an all-share offer, giving continued
optionality. However, where cash is included, investors are compensated
according to a complex formula, in part dependent on how much cash is
present in the offer.
Protection for
convertibles involves
either stepped
conversion terms or an
average premium
enhancement
Protection for
exchangeables centres
on what becomes the
conversion property
watch out for the
treatment of cash
Mandatory structures
1. Introduction
2. PERCS
3. DECS
4. Feline prides
5. Mandatory resets
Introduction
Lower dividend yields in the 1990s created problems for the vast array of US
equity income mutual funds, especially as many of the more exciting (at least
at the time) equity investments were in high-growth technology stocks, which
did not pay dividends. This led to the creation of a whole new class of
mandatory convertible instruments, which give equity investors greater
income in exchange for reduced upside participation. These convertibles
mandatorily convert into ordinary shares at maturity and so there is no
danger of the issuer having to find cash to redeem them. Consequently, there
is only limited optionality for the investor and the exposure profile is very
different from a traditional convertible.
The key difference between a mandatory and a traditional convertible is that
the investor does not have the option to receive cash on redemption (ie, the
option to not convert has gone) and so shares will always be issued. From the
issuers perspective, this means that the convertible should count as equity in
terms of rating/balance sheet. Often, the conversion ratio will change
depending on the price of the shares at maturity. This means that if the share
price rises, often the conversion ratio will fall, reducing the amount of equity
the company has to issue and increasing the attraction from the issuers point
of view, as if the shares rise, investors are effectively buying equity at a
premium. For the outright convertible investor, mandatory convertibles
provide exposure that is almost equivalent to equity, while for the arbitrage
investor, the embedded options in mandatories are very different from a
traditional convertible.
There is a plethora of different acronyms associated with US mandatory
convertibles, as each of the issuing investment banks have come up with
their own name, but in essence, there are two basic structures (PERCS and
DECS), with variations on these structures sometimes altering their
characteristics. In addition, we have considered the different exposure that is
given through Japanese mandatory reset preference shares. Finally, so-called
feline prides have become more popular recently.
developed out of
increased demand for
yield from US equity
income investors
Shares always issued
upon redemption,
therefore bonds count
as equity on balance
sheet
Two basic structures
known as PERCS &
DECS
PERCS
Preferred Equity Redeemable Cumulative Stocks (PERCS) are preferred
shares that automatically convert into one ordinary stock upon maturity,
(which is usually four years). PERCS are usually issued at the prevailing share
price, convertible into one ordinary share, with an enhanced dividend yield.
Other names for PERCS include TARGETS, CHIPS, EYES, PERQS and YEELDS,
though this is a far from an exhaustive list. From the issuers perspective,
these mandatory securities generally count as equity, though as PERCS pay
dividends, the income is distributed post-tax and is a non-deductible
expense.
The redemption in the acronym refers to the fact that these preference
shares have a finite life and the only cash that the investor receives is the
dividend payments. PERCS pay a higher dividend than common shares, but
the equity upside is capped. Above a certain share price, the conversion ratio
will fall as the stock rises, capping the upside at that level. Below this level,
the conversion ratio remains one for one, giving the same downside
exposure as the ordinary shares, excluding the income difference.
Figure 13: Components of a long position in a PERC
Long stock Short call
European style
struck at Cap
Income swap
PERC for Ord
dividends
Analysis involves comparing PV of dividend
income against theoretical call price
In terms of valuation, the PERCS structure is very simple. In buying a PERC at
issue, an investor is essentially buying the shares (less any dividends over the
life of the instrument) and selling a call option struck at the price of the cap.
However, rather than receiving the premium for this short-call option as an
up-front capital payment, the investor will receive an income stream from the
company as a series of dividend payments. Investors modelling PERCS need
only calculate the value of the call they are short and compare that against
the present value of the PERCS income advantage over the ordinary
dividends.
Usually issued at the
prevailing stock price,
convert 1:1 and pay
holders a quarterly
dividend
Investors accept capped
upside for enhanced
yield
Long stock and short
call, fair value of the call
should equate to NPV
of the income
advantage over the
ordinary shares
Figure 14: PERC convertible payoff
Equity
Issue price
PERCS yield
pick-up
Share price
Cap level
T
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n
Generally, the investor does not have American exercise and cannot convert
PERCS ahead of maturity. However, most PERCS are callable at any time by
the issuer, with a call price that declines over time, generally to the level of
the share-price cap. Investors also receive the value of unpaid and accrued
interest. Normally, shares are delivered on PERCS that are called, but
occasionally issuers have the right (but obviously not the obligation!) to
deliver cash. The general equation for the conversion ratio for PERCS that
have been called early is:
Number of shares = (call price + accrued and unpaid dividends)
Market price of the shares
The complicating factor is that the market price of the shares tends to be
determined by an averaging period, which ends before the issuer decides to
call the bond, effectively giving them a look-back option. This obviously
creates risk for the investor, though this is limited, because if the closing price
on the day after the five-day averaging period is significantly below (ie, 95%
or less of the five-day average), then this lower closing price will be used.
Nevertheless, the look-back option clearly gives value to the issuer, though
the issuer will always be paying all unpaid dividends up until maturity and
the lowest call price is generally at the cap level. Therefore, there is little
incentive for the issuer to call the bonds early, even with the look-back.
Callable PERCS (most
are) have a call price
that declines over time
Watch out for averaging
periods and look-back
clauses
One of the difficulties in trading PERCS is that because the instrument is
basically stock with a short-call position, there is negative gamma. This can
be particularly severe approaching maturity if the share price is close to the
level of the cap. (Shorting an ATM call close to maturity is clearly not a great
position to be in!) Figure 15 shows the falling delta as the share price rises
through the cap. Finally, investors should consider that there will be
significant dilution after PERCS mature. The product is structured to suit
equity income accounts and the shares that arise on conversion may well not
yield enough for his class of investor. Therefore, unlike traditional convertible
bonds, it is likely that many outright accounts will hold PERCS through the
conversion process, selling the underlying equity as they receive it. This can
result in technical pressure on the share price, which in turn could create an
excellent technical opportunity for equity investors. Outright PERCS holders
should probably sell ahead of this.
Figure 15: At issue delta of three-year PERC with Euro 130 cap
0%
25%
50%
75%
100%
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200 210 220 230 240 250
Stock (Euro)
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The PERCS structure is very flexible and can easily be modified to alter the
investors exposure. For example, Microsoft issued 2.75% convertible
exchangeable principal-protected preferred shares, which, in addition to the
usual long-stock, short-call structure, also contain a long (stock-settled) put
struck 21.125% out of the money. As always, with a PERCS-type structure, the
optionality is expressed in changes to the conversion ratio, though in this
case, the issuer has the opportunity to deliver cash.
Another variation is to restrict rather than cap the investor. This is done by
effectively reducing the number of short calls within the structure, thereby
giving the investor upside above the cap level albeit at a reduced rate.
Thus, if the structure were effectively short 75% calls, the investor would
retain 25% upside above the level of the cap. Obviously, as the investor has
effectively sold fewer calls, the enhancement to the income will be lower.
PERCS are not immune to the CoPay revolution, though this requires some
significant modifications to the basic structure. As preferred shares, PERCS
pay dividends and are therefore excluded from contingent interest payment
As PERC involves long
stock and short call, the
instrument must have
negative gamma
rules. However, it is possible to achieve CoPay treatment by restructuring
capped equity products as junior subordinated mandatory convertible debt
products. (See the section on CoPays to see why issuers may choose to do
this and what the implications are for both issuer and investor).
DECS
Dividend Enhanced Convertible Stocks (or alternatively Debt Exchangeable
for Common Shares) is the second main type of mandatory structure. These
instruments are generally either preference shares or subordinated bonds,
which, like PERCS, mandatorily convert into ordinary shares at maturity (if
unconverted before this). If the DECS are structured as debt, then the income
will be classed as interest and will be deductible, but preference-share
structures pay post-tax dividends. Other names commonly used for DECS
include PRIDES and ACES.
DECS give no significant downside protection and these instruments are very
equity sensitive, with minimal direct bond characteristics and interest-rate
exposure. Again, as with PERCS, some of the upside performance is given
away and in return, the investor receives an enhanced yield over the ordinary
shares. However, unlike PERCS, the investors upside is not capped with the
DECS structure, but rather the price that the investor pays for the enhanced
income is a zone of flat exposure.
DECS, like most mandatory structures, are far more common in the US than
elsewhere, but despite the relative lack of equity income investors in Europe,
we have still seen a couple of reasonably large DECS issues (National
Grid/Energis and Daimler Chrysler). Nevertheless, Europe has yet to really
embrace mandatory structures and neither of these two issues has really
driven investor interest. Still, DECS remain a very well understood instrument
within the US.
Figure 16: Component parts of a long DECS position
Short European call
option
Three year struck at-the-
money
Long 0.8 European call
option
Three year struck 25% out-of-
the-money
Long stock
Income swap
DECS for Ord
dividends
Analysis involves comparing PV of income
swap against difference in option premiums
Short at-the-money option has greater value
than smaller long out-of-the-money position
DECS can be structured
as either debt or equity
depending on the needs
of the issuer
Retain downside
exposure, but give up
some upside exposure
for an enhanced yield
Predominantly a US
phenomenon
DECS are generally issued at the same price as the underlying shares, but the
conversion ratio depends upon the prevailing stock price at maturity. If the
share price is at the issue price or below, the conversion ratio will be 1:1,
giving the investor all the downside of the shares, though with a significantly
enhanced yield (and therefore a far higher total return). Between the issue
price and a set higher level (generally a premium of 20%-25%), the
conversion price will rise with the share price, such that the investor has
neither capital gain nor loss. Above this level, the investor will regain upside
exposure at the lowest conversion ratio.
Figure 17: DECS convertible payoff
Equity
Issue price
DECS yield
pick-up
Share price
Trigger 1 (Usually
current share price)
Conversion ratio = 1
Trigger 2 Conversion
ratio <1
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With DECS, investors can convert at any time, but only at the lower minimum
conversion ratio. Given the enhanced yield, coupled with the possibility of
getting a higher conversion ratio, there is almost no scenario in which it
would be economic to voluntarily convert early (it would require phenomenal
dividend growth), though an uncompensated corporate action (specifically a
takeover or special dividend) could force early conversion.
As with PERCS, there is often an early redemption feature, with calls common
in the final year of the typical four-year structure. The call is generally at a
small premium to the issue price plus accrued interest, but is payable in stock
(the number of shares that the investor receives will not fall below the
minimum). As the issuer will save interest (or dividends as the case may be) if
the DECS is retired early, calls are likely to be exercised as long as the share
price is high enough to ensure the maximum conversion price. However, if
the shares have not performed, the call will unlikely be used, as this would
lead to higher dilution.
There is a dead zone
between issue price and
an upper limit where
the conversion ratio
adjusts down as the
share price rises
Despite American-style
optionality, there are
very few scenarios in
which it would be
economic to exercise
early
A DECS is like a convertible in that all the embedded optionality is contingent
and when a holder converts, he simply owns shares with no residual option
position. This is significant with DECS (as opposed to PERCS), as the investor
has American exercise and the issuer may have a call option. Consequently, a
true DECS model will be tree based and operate in a similar manner to a
convertible model.
However, it is exceptionally unlikely that a DECS will be voluntarily converted
early by the investor and as the structure is mandatory, the effect of an
issuers call is more limited than with a convertible. Consequently, many
investors split DECS into their basic four components and indeed this will
give a very accurate approximation of the value of the instrument. Looking at
a three-year non-callable DECS with an initial 25% premium, the four
components are:
1. Long one share
2. Short one European three-year call struck at-the-money
3. Long 0.8 European three-year call struck 25% out-of-the-money
4. Income swap of ordinary dividends for DECS payments (ie, NPV of
income advantage).
(Alternatively, the long one share, short one ATM call option can be thought
of as a short one European put at the issue price plus a zero coupon bond
paying the issue price at maturity. In this case, the NPV of the income
advantage is simply replaced by the NPV of the DECS payments. This way of
looking at DECS will give the same result, but makes it harder to
conceptualise and compare DECS against the underlying ordinary shares).
By breaking out the optionality in this way, it becomes necessary to use a
volatility surface when valuing the different options, as the strikes vary
significantly and so investors need to allow for volatility skew. This valuation
methodology also explains where the additional income of the DECS over the
ordinary shares comes from. The short at-the-money option position clearly
has greater value than the smaller long out-of-the-money position and this
difference should represent the NPV of the income swap.
Like a convertible, all
embedded optionality is
contingent
Volatility surfaces
required to value the
different embedded
options
Figure 18: At issue delta of a DECS
0%
20%
40%
60%
80%
100%
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200 210 220 230 240 250
Stock (Euro)
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Delta on short call struck at Euro 100 Delta on long 0.8 call struck at Euro 125 DECS delta
Period of negative
gamma as short option
position picks up delta
faster than long 0.8
option position with
the higher strike
Strike of 0.8
long call
position
Strike of
short call
position
The major problem with this approach is that it makes no allowance for any
callability within the DECS structure. As the two embedded options are
contingent and given that the issuer will only realistically call the bond if the
shares are well above the higher strike of the long call position, the impact of
the call feature on the value of the DECS optionality is small. However,
ending the instrument early will result in a decrease in the instruments
income advantage and will therefore affect its valuation, though subject to
given the path dependency.
For a callable DECS structure and without running the valuation through true
tree-based or finite-difference models, the investor has to make a subjective
estimate of how long the extra income will last and therefore what the impact
of the call will be on the valuation.
Feline prides
Feline prides represent a further enhancement to the DECS structure, in
essence giving greater flexibility by allowing the investor to break the product
up into its constituent parts. This lets the issuer use the structure to tap
several different types of investor simultaneously. The best way to explain
this is to look again at the constituents of a DECS.
1.Short one at-the-money put
2.Zero-coupon bond redeeming at issue price
3.DECS coupon payments
4. Long 0.8 three-year call struck 25% out-of-the-money (illustrative numbers).
This way of looking at a DECS does not allow the easiest comparison against
the shares, but does allow the product to be packaged into two components.
Firstly, the zero coupon bond, which gives redemption equal to the issue
price, must be the issuers credit as they hold the cash. When this is put
together with the DECS dividend payments, investors effectively have a
preference share. (This could be a subordinated bond if the DECS were
structured as junior debt rather than preference capital).
The second element of the DECS is the purchase contract, represented by
the two options. The short put and long call position give the economic
exposure of the mandatory conversion, but in reality, this is a simplification,
as conversion still takes place, even if the shares are between the two
different strikes at maturity. In essence, investors still receive (and have to
pay for) shares, even if both the short put and the long call options end up
out of the money. There are no valuation implications, as investors will
receive stock equal to the issue price. In reality, the investor has entered into
a forward share-purchase contract with a varying conversion ratio, such that
the economic exposure is equivalent to a short put/long call position.
Feline prides let the
investor break the
product into its
constituent parts
The shares are always
issued and optionality
is really a share-
purchase agreement
with short put/long call
economics
Figure 19: Feline prides share-purchase contract
Despite long call short
put economics,
investors ALWAYS
receive shares
Share price
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So by repackaging the constituents, we can view a DECS slightly differently,
with constituents of a:
1. Preference share
2. Share-purchase agreement
This is exactly what the feline prides structure does and the basic DECS unit
is here referred to as an income pride. However, the investor can then break
the unit up and trade (ie, sell) the preference share if desired, eliminating the
credit exposure. This creates a problem for the issuer, in that while the share-
purchase contract is mandatory, if the preference share is sold, the company
has no guarantee that the investor will pay the cash specified under the
purchase agreement.
Consequently, in order to break up the income pride, the investor needs to
collateralise the purchase agreement by placing zero-coupon Treasuries in
trust to meet the purchase cost. The resultant instrument is effectively a
collateralised share-purchase agreement and is generally referred to as a
growth pride. The growth pride does not pay income, but there may be a
nominal structuring fee paid quarterly to the investor.
Income pride = Preference share + share-purchase agreement
Growth pride = Zero-coupon Treasury + share-purchase agreement
Investors can swap (and indeed re-swap) between the two different types of
feline pride by substituting in the required security, allowing investors to strip
out the preference share (or Treasury share should they so choose). Also at
issue, the company can sell a mixture of preference shares, income prides
and growth prides, thereby tapping a wider investor base. Finally, these
instruments tend to be issued out of a trust (see deductible equity and, in
particular, the section on TOPrS) and consequently often have tax calls,
though as they are mandatory securities, the valuation implication is limited.
Figure 20: Repackaging feline prides
Treasury
Income
pride
+
Preference
share
Growth
pride
+
Treasury
Income
pride
=
Preference
share
Growth
pride
=
+
+
Mandatory resets
Reset clauses can be attached to mandatory structures, operating in a similar
manner as with reset bonds. The reset clauses work so that on one or more
specified dates, the conversion price is reset to a level at (or near) the
prevailing share price (ie - if the shares fall, you get more to make up for the
fact that they are worth less). There is always a maximum limit on the
adjustment, which means that the conversion price can be adjusted down to
a certain minimum, often 80% of the initial conversion price at issue. The
reset feature will give investors some downside protection, preventing capital
losses up to the level of the reset floor, acting a little like a bond floor.
Below the reset floor, the instrument will once again pick up exposure to any
further falls in the underlying stock and so investors might not be protected
against particularly sharp falls in the shares. Because reset features give
investors a measure of downside protection, mandatory structures with this
feature have greater value (and therefore will be issued with lower coupons).
In theory, resets can be attached to any mandatory structure, including DECS
and PERCS, but they have most commonly appeared in the Japanese
convertible market, where they have normally been attached to mandatory
securities without any other optionality.
As we have previously said, resets greatly increase the path dependency of
the optionality and consequently increase the difficulties in modelling these
instruments. The difficulties in modelling the feature means that its value to
investors is generally underestimated, though it should always be
remembered that a downwards reset can only increase value for the investor.
Figure 21: Delta of a mandatory preference share with a reset clause
0%
20%
40%
60%
80%
100%
120%
140%
1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201
Parity
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Normal Convertible Mandatory reset
Mandatory reset bonds typically display a
severe inverse correlation between stock
price and delta around the reset level - this
is negative gamma which is bad news for
arbitrageurs as rehedging involves buying
shares high and selling them low
Many of the
characteristics of a reset
bond
Resets provide a
measure of downside
protection
As with reset bonds, mandatory resets exhibit negative gamma and, indeed,
as there is no offsetting bond floor, the situation is far worse. This is because
if the shares are trading in the reset zone, it will seem probable that the
conversion ratio will rise on the reset date and consequently the theoretical
delta will increase as the share price falls. In this situation, an arbitrageur
wishing to remain delta neutral would be forced to sell as the share price falls
and then buy them back were the shares to recover. Consequently, volatility
in this reset zone of negative gamma can cause significant losses for
arbitrage investors. For the sake of clarity, it is worth remembering that resets
add value for the investor and that this negative gamma is simply increasing
the difficulties of arbitrage trading and secondary market making of these
instruments under certain conditions.
It is very difficult to unbundle the optionality embedded within reset
structures, especially where there are multiple resets or where the reset is
ahead of maturity. However, where there is a non-callable structure with a
reset at maturity, the convertible can be split into its component options to
give an accurate valuation and this gives a good theoretical insight into how
the feature works. The best way of showing this is through example.
ABC Corp non-callable mandatory reset preferred
Conversion premium 25%
Parity reset at maturity
Reset floor 80% of reference price at issue
The valuation of each preferred approximates to the following options (all
European exercise with the same maturity as the preferred):
1. NPV of the reset level (usually nominal value)
2. Short 1.25 puts (ie, nominal value/reset floor) struck at the reset floor
3. Long 0.8 calls (ie, nominal value/conversion price) struck at the
conversion price
4. Income swap of ordinary for preferred dividends (i.e. NPV of income
advantage)
Alternatively this can be expressed as:
1. Long one share at the reference price
2. Short one call at the reference price
3. Long 0.8 calls at the conversion price
4. Long one put at the reference price
5. Short 1.25 puts at the reset floor
6. Income swap of ordinary for preferred dividends
The lack of a bond floor
increases the negative
gamma phenomenon
Clearly, this alternative is a more complex (and therefore less likely)
methodology to use, but it does demonstrate how the option bundle is used
to create income. Stripping out the stock, the four option positions have
negative net value. The payment for this option position is the enhanced
income and the income swap should equal the option for the mandatory reset
preferred share to be fairly priced. Some investors use either of the above
two methodologies to calculate the value of Japanese mandatories with
multiple reset dates, valuing the options to the next reset date only. Clearly,
this has limitations, but it can provide a useful approximation of the
structures true value.
Despite being complex,
stripping out the stock
and four option
positions can still be
useful
Zero-coupon bonds and accreting
structures
1. Accreting structures
2. OIDs
3. Premium redemption bonds
4. Double-zero structures
Accreting structures
In terms of valuation, the prevalence of arbitrage (implied volatility) based
models means that the investor can compare across different structures and,
in theory, should therefore be indifferent as to how a bond is structured for
bonds with an equal value (ie, equal implied volatility). Nevertheless, some
investors have a particular sensitivity to income (ie, coupons), especially fund
managers whose own fund pays an annual dividend/coupon to their
underlying investors. Also, for arbitrage investors, the current yield can be a
critical component in the financing of the overall position.
Conversely, from the issuers perspective, the coupon is a pre-tax charge and
a high coupon can therefore have an impact on the companys stated
earnings per share. Consequently, a low running cost (ie, a low coupon) is
often the key variable of the convertible that the issuer wants to minimise. In
this case, the wishes of the investor and the issuer are diametrically opposed.
Nevertheless, as the convertible market tends to be driven by the investors
demand for new issues, issues tend to end up with coupons closer to the
requirements of the issuer than the investor!
Obviously, lowering the coupon reduces the bond floor, which, in turn,
reduces the valuation. This can be mitigated in two ways, which may even be
used together; firstly, by giving the investor puts on the bond and secondly,
by redeeming the bonds at a higher price than that at which they are sold.
Where the bonds redeem at a higher level than the issue price, the fixed-
income value of the convertible will accrete over the life of the instrument.
The combination of this accretion rate, together with any coupons, will make
up the instruments yield to maturity. Accreting structure can take several
different forms, but in essence, the valuation impact is similar.
Negative effect of low
coupon on bond floor
can be offset by puts
and/or a redemption
value above issue price
OID bonds (Original Issue Discount) bonds
Zero-coupon bonds by definition pay no coupons and give investors no
income. Yield to maturity is achieved by means of an issue price below final
redemption value (ie, investors pay 60 today for a bond maturing in five years
at 100 - giving a YTM of around 10.5%). Zero-coupon convertibles were
popularised in the US in the mid-eighties by Merrill Lynch, which introduced
the acronym LYONs (Liquid Yield Option Notes).
The traditional Lyons structure has a maturity of 1520 years, but the bond
will contain rolling puts, often every five years, and generally is callable by
the issuer from the fifth year onwards. Consequently, it is highly probable
that either the put or the call will be exercised in the fifth year, as under
practically all circumstances, it would be optimal for either the issuer or the
investor to exercise their option. Therefore, investors can consider the first
put and call date to be maturity. (Given the put, the bond cannot be worth
less than this).
Figure 22: Zero-coupon convertible defensive security
Equity
Issue price
Share price
Conversion
price at issue
Effective
conversion price at
maturity
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Roche 0% 2010 USD is a good example of this structure. The bond was issued
at 35.628 on 20 April 1995 and redeems at par (100) in 2010, giving a YTM of
7% from issue. The next put is in 2003, when the bond also becomes callable,
and so we expect this issue to disappear next year. Calls and puts are
calculated according to accreted value. Accreted value is the price that keeps
the yield to maturity constant. Roche 0% 2010 USD is callable on 20 April
2003 at 61.778, which represents a 7% yield from issue.
When an investor converts a zero-coupon bond, the accreted interest is lost.
Consequently, the effective conversion price will accrete over the life of the
bond and the maturity payoff diagram shows that the return on the bond will
Yield provided via an
issue price below the
final redemption value;
widely used in the US
market
LYONS are usually long-
dated bonds with
rolling puts and usually
callable from fifth
anniversary onwards
Roche 10s & 12s
provide good examples
of the structure
Accreted interest lost
on conversion
remain constant unless the share price rises very significantly by maturity.
The difference between the conversion price based on the issue price and the
conversion price based on the final redemption price is the disadvantage
(from an investors point of view) inherent in zeros, though investors should
remember that this is taken into account in arbitrage valuations.
There are clear positives to the issuer in using a zero-coupon structure;
principally, there will obviously be no cash running cost of the bond and the
effective conversion price of the bond will increase as the bond accretes
towards par. Also, the accretion rate is tax deductible in all major
jurisdictions, giving the issue a tax shield for interest that has not been paid,
while the EPS dilution will be minimal or small.
Of course this is not a one-way street and Lyons have a higher yield than
equivalent current coupon bonds, assuming conversion does not take place,
and indeed the probability of conversion is reduced due to the escalating
premium. If conversion does not occur, the company will have to pay out the
principal and all the accreted interest in one single transaction, possibly
creating liquidity and refinancing problems for the issuer.
Zero-coupon OID bonds received a huge new lease of life in the US in 2000 as
a result of the contingency revolution; both CoCo and CoPay bonds have
been discussed at length in other sections.
Issuer benefits from no
cash running costs and
an accreting conversion
price
but provide investors
with a higher yield than
equivalent current
coupon bonds
Premium redemption bonds
In Europe, bonds are also frequently issued below their redemption price, but
often still retain a small coupon, generally for two reasons. Firstly, many
European investors are loath to buy convertibles with lower income than the
underlying shares and so there is significant pressure from investors for new
issues to have a coupon at least as large as the dividend yield. This is not to
say that deals do not occur with coupons below the dividend yield, but rather
that this is far less frequent than in the US.
Also, in some European countries, there is some uncertainty as to how zero-
coupon convertibles will be treated for corporate tax purposes. In Germany,
some issuers are concerned that tax authorities will break up zero-coupon
convertibles into the component equity options and treat these bonds
differently for tax purposes. Consequently, some issuers will have a
nominally low coupon, even if this is not strictly needed.
Figure 23: Zero-coupon convertible is comprised entirely of equity derivatives
Long stock
Accreting
equity put
Dividends
This leads neatly into the other major difference between the US and
European convertibles markets with regard to accreting structures. In the US,
the OID structure is the most common accreting structure, while in Europe
(including the UK, but less so in Switzerland), premium redemption is the
standard for accreting convertibles. Here, bonds are not issued at a discount
to their nominal value, but rather redeem at a premium. From both the
issuers and the investors perspective, the economics of premium
redemption versus original issue discount are identical and, indeed, just
represent a scaling up or down on the basis of the individual bonds.
Premium redemption
structures often provide
YTM with a low coupon
OIDs standard in the
US, while premium
redemption structures
more prevalent in the
European market
Table 1: Premium redemption versus OID stucture
Premium redemption Original issue discount
Issue price 100% 50%
Issue size $100m $200m
Proceeds $100m $100m
Coupon 2% 1%
Cost per coupon $2m $2m
Redemption price 200% 100%
Redemption proceeds $200m $200m
Conv. price per nominal $10 per share $20 per share
Conv. price at maturity $20 per share $20 per share
Total number of shares 10 million shares 10 million shares
Source: Deutsche Bank estimates
As the table above demonstrates, there is no difference to either the issuer or
the investor between the two structures in terms of interest payments and
effective conversion price of the bond. However, the premium redemption
structure does allow easier comparison against current coupon bonds for
accreting structures that also contain coupons and this in part explains why
Europe continues to follow the premium redemption structure, while the OID
convention is more popular in the US.
However, the reason why the different structures were developed in the first
place is that in certain European jurisdictions, OID structures have historically
been treated differently for tax or accounting purposes and, indeed, in some
locations, it was simply not possible to issue bonds at a discount to nominal
value. These historical differences have now lapsed and there is no difference
in treatment between the two structures, but nevertheless, the two different
conventions remain.
Indeed, the OID structure is simply not possible for issuers who wish to use
the French conventions, as here, bonds are issued at their nominal value
(trading dirty and converting on a one-for-one basis). Consequently, French
issuers who want to use accreting structures have to issue premium
redemption bonds if they wish to follow French market conventions. Of
course, there is nothing from a legal, tax or accounting perspective to stop a
French issuer from adopting the standard Euro-market conventions, but the
French conventions remain as popular as ever with French issuers.
Equity dilution and
interest cost unaffected
by choice of OID or
premium redemption
structure
Historically, certain tax
and accounting
practices responsible
for limiting use of OID
structure in Europe
Double-zero structures
A more recent innovation has been the issue of convertibles without either
income or yield, ie, bonds that have no coupons and also zero accretion rates.
Consequently, the conversion price remains fixed throughout the life of the
bond and, indeed, as there is no yield, the conversion price will be lower than
with other structures. The bond floor that generates option value for investors
and therefore premium for the issuers is created by a series of short-dated
puts. Indeed, this structure seems to be ideal for issuers, as clearly, it will be
EPS accretive and at redemption/conversion there will be no implicit interest.
However, what is great for issuers in this case does not necessarily suit
investors and this will obviously be reflected in the pricing attained.
Figure 24: Double-zero convertible
Long stock
Rolling Puts
European style
struck at the
conversion price
Dividends
The structure is in essence simply stock minus dividends plus a string of
European stock puts struck at the conversion price. Clearly, this limits the
type of investors who will be interested in the structure at issue, bond funds
get no yield and equity funds get no income. Indeed, even for dedicated
convertible funds, lack of yield is often a disadvantage, and this structure
therefore has a much more limited investor base even than zero-coupon
accreting structures. Finally the short dated puts needed to keep the bond
floor high increase the likelihood that the issuer will be faced with a large
and, indeed, uncontrolled cash outflow, possibly creating liquidity and
refinancing problems.
Issuance of double-zero bonds has been limited to just a couple of issues in
Europe, but in Asia and, in particular, Taiwan, many issuers like the structure,
as these companies tend to issue very low premium bonds and often have a
strong desire to preserve interest expense.
Zero-coupon, zero-yield
issues usually have low
premiums and a
number of short-dated
puts
Lack of yield the
primary concern for
many investors
Convertibles and the balance sheet
1. Convertibles and the balance sheet
2. Subordinated bonds
3. Structural subordination
4. Preference shares
5. Deductible equity
6. Convertible capital bonds
7. Soft mandatory redemption
Convertibles and the balance sheet
One of the key criteria with an issuing company is where a convertible will sit
within its balance sheet and therefore what the implications will be for credit
ratings of other public debt. Indeed, depending on how a deal is structured, a
convertible may even class as equity. Naturally, many issuers want to
minimise the impact of convertible issuance on their existing debt (even if
this bears a higher cost). Obviously, longer maturity bonds have a lower
impact, especially perpetual bonds, and indeed, some convertibles have
deferrable interest specifically to be considered closer to equity.
However, the most common way in which issues are made closer to equity is
by altering the ranking of the convertible. This has increased the popularity of
two structures: subordinated convertible bonds and convertible preference
shares. In the European convertible market, subordinated bonds are far more
common than convertible preference shares. This is because preference
shares pay their interest post-tax and this effectively raises the cost of the
instrument unless the investor can claim a tax credit (which needs to be
included in the at-issue pricing in order to make the instrument competitive
from the issuer's perspective). Indeed, in the UK, there was an active
domestic convertible preference share market until Advanced Corporation
Tax and the associated dividend tax credit were abolished. After this, the UK
domestic convertibles market has all but ended, though a few rump issues
remain outstanding.
Figure 25: Subordinated bonds and preference shares may receive equity credit
Debentures /
Secured
Senior /
Unsecured
Subordinated
Unsecured
Preference
shares
Ordinary
shares
Possible equity
treatment
Debt
treatment
Equity
treatment
A primary concern of
issuers is where any
capital raised will sit on
their balance sheet
Both subordinated
convertibles and
convertible preference
shares move an issue
closer to equity
Subordinated bonds
Subordinated bonds count as debt for tax purposes and rank ahead of all
equity (including preference shares) in a winding up of the issuer. However,
subordinated bonds will not receive any payments until all obligations to
senior bondholders have been met and this is the reason why the impact of
subordinated issues on senior bond ratings is mitigated. From the
perspective of the investor, the impact of subordination can be difficult to
assess.
The amount of senior debt at the time of issuance is a clear indicator as to
how much wider subordinated debt should trade, but investors should be
aware that subordinated debt rarely, if ever, contains negative pledges or
restrictive covenants. Therefore, senior debt can and is likely to be increased
if the issuer gets into financial difficulties and this may reduce the issuers
ability to meet its obligations to holders of subordinated debt. The quality of
subordinated debt may well be diminished even further if the issuer pledges
assets as security when refinancing senior bonds.
Finally, subordination can have a severe impact on the investor base. This
can be from two perspectives. Firstly, some investors cannot take (or have
lower limits on) subordinated debt. Secondly, subordinated debt will have a
lower credit rating (which, in itself, is likely to affect the investors limits), but
even more significantly, if the rating falls below investment grade, this will
impact the potential investor base greatly. Finally, the market for
subordinated debt within credit derivatives is at best highly limited and so
this reference point is often missing for investors, increasing the risk.
Subordination is likely to remain a feature of the European market and
investors need to know how to value these issues. Very high credit quality
companies (eg, AXA) may be able to maintain solid stable investment grade
ratings on subordinated issues, even with a liquid credit derivatives market
(both asset swap and CDSs have been available for subordinated AXA paper).
Under such circumstances, the credit derivative spread allows easy valuation
of the convertible.
However, with many other issues, this is not the case and, indeed, in the
Netherlands, in particular, there are many unrated subordinated bonds. As a
rule of thumb, investors should assume that subordinated paper is at least
one notch lower than senior unsecured debt, though in fact, subordination
may have a greater impact upon the rating of the bond than this. Finally,
subordinated debt is likely to see a far more severe negative reaction than
senior debt if the issuer gets into (or is perceived to be getting into) financial
difficulties. Some investors use deep out-of-the-money equity puts to help
hedge subordinated debt.
Despite counting as
debt, subordinated
bonds usually have
limited impact on senior
bonds
Rarely contain negative
pledges or restrictive
covenants
Investor base restricted
by limits on
subordinated debt
and/or investment-
grade ranking
Figure 26: Yield on subordinated CB versus senior straight bond
4
6
8
10
12
14
16
18
20
Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01
Y
i
e
l
d

%
KPN 6.25% 2005 EUR Straight
KPN 3.5% 2005 EUR CB
Source: Bloomberg, Deutsche Bank
Structural subordination
Investors should be aware that the title of the bond does not necessarily
indicate where a bond will rank against other debt within the issuers group
of companies. Normally, most debt will be issued or guaranteed out of the
head holding company, and what will be important to the investor is how
their bond ranks with other debt within the holding company. Occasionally,
senior bonds from a financial subsidiary or SPV will only have a subordinated
guarantee from the group holding company (KBC 2.5% 2005 Euro is a good
example of this). Clearly, here, investors should consider the debt as
subordinated debt of the parent.
However, far more serious and often far less apparent is when the debt of the
senior company has fewer rights than the debt of its operating subsidiaries.
This is similar to the situation of subsidiary exchangeables, except that rather
than issuing out of the higher-rated subsidiary, the bond is sold from the
lower ranked parent. In essence, the parents only assets are its
shareholdings (often 100%) in its operating subsidiaries. If these subsidiaries
themselves have gearing, in a winding up, all debt at the subsidiary level
(including subordinated debt and even potentially redeemable preference
shares of the subsidiary) would have to be repaid before the parent receives
any cash.
Consequently, any debt at the parent level (even senior) is effectively
subordinated by the groups structure. A good example is provided by the
two Telewest convertibles, which are both senior, but with structural
subordination, and indeed here, this is very well explained within the issues
documentation.
Figure 27: Structural subordination
Parent
company
Subsidiary
A
Subsidiary
C
Subsidiary
B
Senior
bonds
Bank
loans
Senior
bonds
Bank
loans
Senior
bonds
Bank
loans
Senior
bonds
Bank
loans
All redeemable
investors at the
subsidiary level get
paid out before parent
receives a penny
In this example, debt held
at the parent company is
the last to get paid out!
Senior debt at the
subsidiary level may be
guaranteed only on a
subordinated basis
With structural
subordination,
subsidiary debt
(including prefs) has
greater rights than
senior parent debt
Preference shares
The abolition of the dividend tax credit effectively ended the UK preference
share market and the high cost to the issuer of post-tax preference-share
dividends versus interest payments means that convertible preference shares
have not really caught on within other parts of the European market. Indeed,
in Holland, for example, the subordinated debt market has been used in place
of preference shares and some Dutch lenders will give balance-sheet credit to
domestic subordinated issues similar to that for preference shares.
However, in the US, the high number of equity income mutual funds (which
are also instrumental in the development of the US mandatory market) has
lead to a significant number of issuers of convertible preference shares.
These preference shares often offer a significant yield enhancement over the
ordinary shares, though obviously for a premium.
US preference shares often have a nominal value of $50 and there are a
number of other differences between these convertible preference shares and
standard convertibles bonds. As with all preference shares, missing a
preference dividend is not an act of default, but the issuer is prevented from
paying ordinary dividends while preference dividends are in default this is a
critical difference between preference shares and subordinated bonds.
Indeed, some of these issues are true equity and are irredeemable (ie, these
preferred are equity, in that the issuer is not obliged to ever give the investor
their money back or indeed to ever pay any dividends). The market
convention for irredeemable preference shares is to treat them as 50-year
redeemable structures. While this is clearly inaccurate, the NPV of
redemption 50 years out is so small that this inaccuracy is not material,
especially as the credit spread and therefore discount rate on these bonds
tends to be high.
The conventions for US preference shares differ from those for convertible
bonds. Almost always, these issues have an official listing on the NYSE and
therefore have documentation that meets the appropriate requirements. The
preference dividends tend to mirror ordinary dividends and therefore are
usually paid quarterly. Also, as preference payments do not count as true
interest, accrued is not broken out within the price and preference shares will
trade dirty.
Preference shares will rank junior to all debt. However, whereas outside the
US all preference shares tend to rank equally, US issuers will often issue
different series of preference shares with different rankings (ie, senior
preference shares, junior preference shares, etc). While issues within the
same series will rank equally, this still creates an extra layer of complexity
when analysing the balance sheet and appropriate credit spreads.
One of the more recent innovations allows preference shares to be re-
marketed at maturity. This provision allows the issuer to extend the maturity
by changing the coupon to an appropriate level, potentially procuring new
buyers for the instrument. This provides the issuer with an alternative to
simple cash redemption, potentially reducing refinancing problems and
making the instrument more equity-like.
Demand from equity
income funds has led to
significant issuance in
the US
Missing a preference
dividend is not
necessarily an act of
default
and the principal
never needs to be
repaid with an
irredeemable preference
share
Re-marketable
preference shares allow
issuers to extend
maturities
Deductible equity
From the issuers perspective, the ideal structure would be an issue that
counts as equity on the balance sheet, but which the tax authorities
considered to be an interest payment, allowing payments to be made pre-tax
and thereby effectively reducing the cost to the issuer by the corporation tax
rate. This represents something of a holy grail for issuers, a structure that in
theory strengthens the balance sheet, but which is partially paid for by the tax
authorities.
A number of different structures have been developed globally, which give
this treatment, though in reality, all are very similar. Often, the exact nature of
the structure will have to vary depending upon the specific tax and
accounting regime of the issuer. In essence, all these structures involve
issuance from a special purpose vehicle that will give equity on consolidation,
but payments are made via inter-company loans and are generally tax
deductible.
TOPrS, QuIPS and MIPS
In the US, several structures were developed in the mid-1990s that give the
issuer a measure of equity treatment, but with dividend payments that are tax
deductible. Of these, the TOPrS (Trust Originated Preferred Securities) or
QuIPS (Quarterly Income Preferred Securities) are probably the most generic,
though in reality, they are all based on pretty much the same structure and
give the issuer very similar benefits.
The instruments themselves are essentially convertible preference shares,
usually paying quarterly dividends and quite often with long maturities (to
increase the equity credit), which in some cases may even be extendable.
Conversion is usually American and there is normally a call after five years
(though call protection in some cases is shorter). From the investors
perspective, the instrument is exactly the same as a convertible preference
share, with the same characteristics, and should be valued as such.
The benefit to the issuer lies in the structure behind the TOPrS rather than in
the instrument itself. The issuing company sets up a Delaware Statutory
Business Trust as an SPV to actually sell the preference shares to the
investors. The Trust buys convertible subordinated debentures from the
parent company and sells TOPrS with exactly the same terms to the public
(indeed, these preferred securities may even be secured against the
subordinated convertible debentures). The key factor is that the parent owns
all of the ordinary shares in the Trust and this allows full consolidation.
Deductible equity is
something of a holy
grail for issuers
Figure 28: Structure of a TOPrS
Issuer
Trust
(SPV)
Nominal amounts, maturity
and cash flows identical on
both sides of transaction
Subordinated
debenture +
interest
payments
Preferred shares
+ quarterly
dividend
Public
Cash Cash
As the trust is fully consolidated, the liability of the debentures from the
parents perspective is matched and cancelled out by the debentures as an
asset of the Trust and so the debentures do not appear on the parents
balance sheet. This simply leaves the preferred securities of the Trust as new
equity (on a consolidated basis) for the parent. As the parent does actually
make interest payments on the debentures, these interest payments are tax
deductible. One other feature that investors should be aware of is that in
order to increase the equity accounting, interest on the debentures (and
indeed the preferred securities) can be deferred and rolled up, generally for at
least five years.
MIPS (Monthly Income Preferred Securities) are a variation on the theme,
with income being paid monthly rather quarterly. Sometimes, these are
issued out of limited partnerships rather than Delaware Trusts, but while the
instrument for the investor may seem slightly different (and indeed, the
investor may need to account for these instruments differently), the net effect
for the issuer is the same.
Regardless of why these structures are used, from the investors perspective,
the exact nature of the internal workings of the special purpose vehicle and
the resulting tax, regulation and/or accounting treatment are not relevant
(except to the extent that they may have an impact on the shares). Investors
should simply focus on the guarantees and status of the instrument that they
have purchased and, in particular, what security they have in a winding up of
the parent company. This should allow investors to see exactly where they
rank and correspondingly what credit spread is appropriate.
Convertible capital bonds
The US isnt the only place where this type of structure has been used and,
indeed, in the early 1990s, many UK corporations used a similar idea to issue
convertible capital bonds from offshore (mainly Channel Island) SPVs.
However, the loophole was closed in the mid-1990s. Nevertheless, issuers
have found other uses for the same structure and, specifically for non-sterling
convertibles, it has been used to avoid the SDRT (stamp duty) charge, which
is applicable only for new shares issued in currencies other than sterling.
SDRT is avoided because the bonds first convert into sterling-denominated
exchangeable redeemable preference shares (ERPS) of the SPV, which is
offshore and therefore not liable for stamp duty. The ERPS then immediately
and mandatorily convert into shares of the parent at the prevailing rate and
as these as sterling denominated, conversion does not attract stamp.
Figure 29: Convertible capital bond structure
SPV Corp
Bondholders
Cash
Guaranteed
Bonds
SPV Corp
Bondholders
Bonds
ERPS
ERPS
Shares
Inter-co
loan
Inter-co
loan
On issue:
On conversion:
Use of the old capital
bond structure
demonstrates
innovation within the
CB market
An even more recent development has seen the same structure used by
United Business Media to get round the UK pre-emption rules. The legal
argument put forward is that the consideration for the right to convert the
bonds into parent company shares is the ERPS and not cash and so the
argument concludes that the statutory pre-emption rights of the UK
Companies Act do not apply. This is similar in idea, though different in
actuality, to the cash-box placing structure also used to avoid pre-emption.
The convertible capital bond structure no longer gives deductible equity
treatment for the issuer, but it is an excellent example of how different
structures can be recycled to meet different needs.
One concern for investors, common to all of these deductible equity
structures, is the added complexity within the documentation. For example,
conversion of the capital bond structure goes through an intermediate step of
conversion into the SPVs preference share capital, which then converts into
ordinary shares of the parent. However, it is the documentation of the
intermediate preference shares that tells how the conversion ratio will be
adjusted rather than the documentation of the convertible bond. In the event
of a change of control, the bond documentation will contain the details of any
investor poison put, but it will be the documentation of the preference
shares that contains any enhancements to the conversion ratio. Investors
who do not carefully read the documentation may miss out.
Structure now used to
avoid pre-emption
rights
Soft mandatory redemption
One of the key problems from the issuers perspective is uncertainty. While
the cost of the convertible is cheaper than straight debt, assuming the bond is
redeemed and cheaper than an equity issue if the bond is converted, there is
no way of knowing in advance whether the shares will be issued or not. A
recent innovation, which has yet to be used with any regularity, at least
partially solves this problem. Here, the issuer has the right (but not the
obligation) to redeem the bond in shares, but unlike with a mandatory
structure, the value that an investor receives is made up to par. The top-up is
generally in cash, though the redemption proceeds could be topped up with
additional shares. From the investors perspective, the value of the bond is
unaltered as long as the shares received on redemption can be hedged.
From the issuers perspective, the soft mandatory feature really does alter the
nature of the convertible. The issuer can guarantee that the shares underlying
the convertible will be issued, but is then short a net settled put option on the
shares. There is also a dividend for interest swap.
Figure 30: The soft mandatory structure
Long stock
Net settled
put option
Income swap
Clearly, the fact that the shares can be issued under any circumstances has
implications for the rating agencies and effectively strengthens the issuers
balance sheet. The issuing company is not obliged to redeem in shares, but
can simply deliver cash to investors upon redemption. This ability to deliver
cash gives the company great flexibility over its balance sheet, effectively
allowing the issuer to conduct a share buyback at maturity of the bond.
Consequently, the soft mandatory structure gives a lot of flexibility to the
issuer and yet seems to take little value away from the investor.
The key question in terms of value is whether the shares that are delivered
upon redemption can be hedged, or whether the mechanism that determines
the value of the underlying shares (and therefore the value of the cash to be
delivered) contains a look-back option for the issuer. The current soft
mandatory structures contain no look-backs and so can generally be hedged
and there is therefore no theoretical loss of value to the investor.
Soft mandatory
structure removes
company uncertainty as
to whether shares will
be issued
Ahold soft mandatory clause
Unless previously redeemed, converted or purchased and cancelled as herein
provided, the Company will redeem the Convertible Notes at their principal
amount together with any interest accrued to the date of such redemption on
September 30, 2003. The Company may elect to deliver Common Shares plus
payment of a compensation amount (the Compensation Amount) upon the
maturity of the Convertible Notes instead of redeeming the Convertible Notes
for cash at their aggregate principal amount together with accrued interest. The
Company shall exercise this election by giving an irrevocable notice, no later
than September 15, pursuant to the notice provisions set out herein. Failure to
give such notice will be deemed to be an election of the Company to redeem the
Convertible Notes for cash at their aggregate principal amount together with
accrued interest.
If the Company elects to deliver Common Shares and to pay a Compensation
Amount, the Company shall, on September 30, 2003, deliver the number of
Common Shares which correspond to the principal amount of Convertible Notes
outstanding divided by the Conversion Price and pay a Compensation Amount
per NLG 1,000 principal amount of Convertible Notes which shall be calculated
on the basis of the following formula:
K = NLG 1,000 (NXT)
Where
K = the Compensation Amount
N = the number of Common Shares delivered, and
T= the Trading Price
However, under no circumstances will the Compensation Amount be less than
zero.
Source : Ahold 3% 2003 Euro Bond Prospectus
When the soft mandatory clause has been exercised, the investor has shares
plus a put rather than cash plus a call. The shares will be delivered in all
circumstances, but if the stock falls, the investor receives the additional cash
payments under the soft mandatory clause (ie, the investor is compensated
on the downside). Where the company has already announced that the soft
mandatory clause will be exercised, but where the conversion rights of the
bonds have not expired, the investor is best served closing out the stock
position over the averaging period, while retaining (or selling) the stock-
settled put.
The final consideration for investors is the impact on the credit. All
obligations under the bond will be at the stated level, including the cash
component of redemption. In the event of early redemption, cash has to be
delivered and in the event of default, investors have a cash claim at whatever
level the bond is ranked (ie, senior, subordinated, etc). Assuming the shares
delivered on redemption can be hedged, in theory, there should be no impact
on credit.
However, many credit derivative contracts (both asset swap and CDS) require
that the credit buyer can only receive cash on redemption and this means that
bonds with soft mandatory features may not be deliverable against CDSs and
may not be as liquid in the asset swap market. So, even though no greater
risk is involved to the investor, soft mandatory structures may trade wider
than traditional convertibles by the same issuer as hedging the credit may be
more expensive. Consequently there may be a cost to the issuer in using the
soft mandatory feature.
Other structures
1. CoPay convertibles
2. Bonds with warrants
3. Coupon changes
4. Credit enhancements/repackaging of bonds
5. Event puts
6. Tax/Regulatory calls
CoPay convertibles
CoPay features represent the second and in many ways the more powerful
part of the contingency revolution that powered the extraordinary growth of
the US convertible market last year. The individual contingent payment
features can be much more varied than the different CoCo structures, but all
have characteristics that potentially allow them to be classified under the US
IRS's Contingent Payment Debt Instrument (CPDI) regulations.
Such classification allows the issuer to claim annual deductions based on the
normalised non-convertible cost of debt (which will be stated in the bonds
documentation). Given that many of these bonds are zero-coupon
instruments, this is extremely beneficial, especially when coupled with the
CoCo structure, as the company will not have to account for any initial
dilution and will receive a very substantial tax shield, despite no annual
interest payments. For example, D.R. Horton 0% 2021 USD convertible has a
YTM of 3.25%, whereas the company stated that its comparable non-
convertible yield would be 8.88% - the CoPay feature gives a very sizeable
enhancement to the tax shield.
Figure 31: Example of a CoPay structure
75
100
125
150
175
200
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
No contingent
payment
No contingent
payment
Contingent payment
Contingent payment
Trigger price
Accreted bond value
Issue price
However, it is not certain whether the IRS will indefinitely allow CoPay
structures to bring the instruments under the wing of CPDI regulations.
Indeed, no official ruling either way has ever been given. It is even possible
(though unlikely) that the IRS will act retrospectively, ruling that existing
CoPay convertibles should not fall under CPDI regulations. To fully
understand the situation, it is necessary to understand the CPDI regulations
themselves.
CoPay features
represent the second
and in many ways the
more powerful part of
the contingency
revolution
The CPDI regulations were introduced to close a loophole that allowed retail
investors to avoid income tax. Prior to these regulations, by making a fixed-
income products payout contingent upon some external variable (for
example, an equity index) the actual yield of the product contained a measure
of uncertainty and therefore the investor did not have to realise the interest
on an accruing basis. However, the IRS ruled that no investor would buy such
a product unless it returned at least the issuers normal yield for debt of
comparable rank. And so the investor became required to recognise income
at this normalised rate, regardless of whether any cash payments were made
and regardless of the contingency upon which that interest depended.
Conversion rights themselves are effectively a contingent payment allowing
the issuer to sell bonds below there normalised yield to maturity and, indeed,
exchangeable bonds do fall under the CPDI regulations. However,
convertibles were explicitly excluded from the regulations, in particular
because of the prevalence and success of the LYONs structures within the US
market. Bringing LYONs under the CPDI regulations would have created large
tax deductions for issuers with big (and poorly understood) tax liabilities for
traditional onshore US domestic investors.
The aggressive tax stance being taken by CoPay issuers is that it is the
conversion rights have been excluded from triggering the contingency
regulations, rather than a blanket exclusion on convertible bonds per se. The
issuers argue that by introducing separate contingency features into the
bond, the convertible then falls under the CPDI regulations. Of course, if the
IRS were to rule that the exclusion applied to convertible bonds themselves
(as opposed to the conversion rights embedded within convertible bonds),
then CoPay bonds would not fall under the CPDI, and the issuers would cease
to get the favourable tax treatment. However, as at the time of writing, the
IRS has remained silent, which would seem to be positive for the structure.
The enhanced deduction taken annually through the CoPay structure is taken
into account at maturity. Consequently, if the issuer redeems the convertible
at its accreted value (which will represent a far lower yield to maturity than
the normalised rate at which deductions for tax have been made), the
company will make an exceptional gain and will have tax to pay. Of course,
the issuer still has a considerable timing benefit and the NPV of tax paid is far
lower through the CoPay structure. This advantage increases with the length
of time to redemption and this may influence call decisions, acting as a
disincentive for issuers to redeem CoPay bonds early.
The issuer can also achieve a considerable tax benefit upon conversion.
Parity of the bond at conversion is taken as an interest payment (even if the
cash-out option is not used and the company delivers shares!). Consequently
if parity is above the accreted value (and investors would not convert if this
were not the case), this will reduce the issuers tax bill. Indeed, if parity is
high enough to give investors a return greater than the companys
normalised rate, then the company will be able to make an additional
deduction against tax. From the companys perspective, the cost of being
short shares through the convertibles optionality is reduced by their tax rate
(ie, the shares only have a delta of 65% on the upside!). In reality, this means
that for every 100 embedded call options sold through a CoPay, the issuer
effectively gets 35 back from the tax authorities, seriously reducing the cost of
the optionality sold through the bond.
Convertibles were
explicitly excluded from
the CPDI regulations..
. issuers argue that by
introducing separate
contingency features,
the convertible then
falls under the CPDI
regulations
This looks a compelling argument from the issuers perspective and, indeed,
we estimate that nearly $40bn of last years record US domestic convertible
issuance contained CoPay provisions. The most common type of contingent
payment is an additional coupon equal to the higher of the dividend yield of
the stock or 50 basis points, if the convertible trades above 120% of its
accreted value. However, some bonds contain additional payments if the
shares trade below a specified trigger level (generally 60% of the accreted
conversion price). However, the contingent payments do not kick in until after
the hard call period expires and so the issuer can always avoid them if they
so choose.
Table 2: CoPay Alternatives
Trigger basis Trigger event Contingency payment/ adjustment
Bond price Bond trades above 120% of accreted value Equal to the dividend yield on the stock, or 50 bps,
whichever is higher
Stock price Stock trades below 60% of accreted value Accretion rate is increased to provide a YTM in line
with cost of straight debt and issuer makes a cash
payment of 25 bps
Of course, if the issuer can get a tax shield, this has implications for some
investors. Investors who are onshore (ie, who are liable for US taxation) have
to account for phantom income on CoPay convertibles, which leads to an
annual tax liability as if they had received a coupon equal to the issuers
normalised borrowing rate. If the bond redeems, the investor will have
overpaid tax and so will get a tax credit, but the NPV of the tax credit will be
way lower than the tax paid on the phantom income. Also, on conversion, the
investor will have to pay income tax on any returns above the conversion
price. So the tax treatment for onshore investors is the matching opposite of
that received by the issuer (and is therefore dreadful).
For this reason, these securities tend to be marketed towards tax-exempt
offshore funds (particularly hedge funds). However, the tax liabilities
associated with investing in CoPay bonds are far from certain (especially for
onshore European funds) and, in particular, the tax situation that would arise
on conversion seems unclear. As these bonds are a recent innovation with
long maturities, this has yet to be tested and indeed is unlikely to be tested in
the near future.
The contingent interest rules are a US tax regulation that does not apply in
other jurisdictions. But there is nothing to prevent foreign companies issuing
bonds out of US subsidiaries and most large multinational corporations have
US tax-paying subsidiaries that can be used. There are certain complexities
involved with this and, specifically, it can create problems for the subsidiary
to get rights over the parent companys shares in order to match the short
conversion option. Nevertheless, these problems are not insurmountable
and, indeed, Roches main US subsidiary (Roche Inc) issued the first CoPay
convertible from a European company in July last year.
There are some limiting factors. Firstly, the company must have a US
subsidiary with substantial profitability CoPays can only save US tax and
without US profitability, there is no tax to save. Secondly, a consideration of
the US rules on thin capitalisation is needed, as the US authorities restrict
tax deduction of subsidiaries of foreign corporations that have excessive
gearing, effectively preventing foreign corporations from using excessive
debt to repatriate all US-generated profits without paying US taxes.
Nevertheless, a substantial number of international and especially European
Contingent payments
do not kick in until after
the hard call period
expires and so the
issuer can always avoid
them
There is nothing to
prevent foreign
companies issuing
CoPay bonds out of US
subsidiaries
issues have the potential to follow Roche and issue CoPay bonds out of their
US subsidiaries.
Phones and Zones have also used the CPDI regulations to create an
exceptionally advantageous tax structure. These are exchangeable securities,
with mandatory conversion at redemption, effectively giving delta one
exposure to investors. However, the long maturity gives the issuer significant
tax advantages, effectively delaying capital gains from the disposal until
conversion. Conversion is generally American, but the investor loses 5% if
conversion takes place before maturity, unless the instrument is called. The
issuer can call the bonds early, though the investor still just receives the
shares, and the call feature was principally included to ensure that the
instruments received equity treatment.
Phones and Zones also include contingent payment features where the issuer
can make stock interest payments on the bond at various times during its
life. This amount is deducted from the principal due at maturity (in reality,
this has little impact on valuation and is simply a partial early mandatory
conversion). These contingent payments brought the instruments under the
CPDI regulations, allowing the issuer to deduct their normalised borrowing
rate, greatly improving the timing of tax payments by the issuer and therefore
creating tax NPV gains. However, recent accountancy changes make it less
likely that these instruments will qualify as equity and so future issuance is
likely to be limited at best.
Recent accountancy
changes make it less
likely that Phones and
Zones will qualify as
equity
Bonds with warrants
Some convertibles are issued as bonds with warrants and where the warrants
can be detached, investors will strip the warrants from the bonds and they
will trade separately. Correspondingly, an issue of bonds with freely
detachable warrants should be thought of and indeed has the economics of a
bond issue with a separate warrant issue. Where the warrants cannot be
detached, the instrument will behave exactly like a convertible and will be
valued as such. However, this does beg the question as to why the bond is
structured in this way.
The recently issued Nestle turbo structure is a good example and can be used
to explain the structure from an issuers perspective. Here, different
subsidiaries wish to issue the different components within the convertible,
with the debt portion coming from the US, possibly using a CoPay structure
to get favourable tax treatment, while the equity component comes from a
different subsidiary, often an offshore SPV. Both components are guaranteed
by the parent and are then stapled together and sold as a convertible.
The structure itself does not enhance the accounting treatment of the issuer.
The advantage to the issuer is that each of the debt and equity components
can be issued out of whichever subsidiary is optimal for that particular
component. Often, this will mean that the debt component will come from the
US (assuming the issuer does not have a problem with the Thin Capitalisation
rules), while the warrant will come from wherever it is easiest to get access to
the shares.
Figure 32: Turbo mechanics
Guaranteed Guaranteed
Issue call
warrant
Issue of
note
Issue stapled note
to market
Corp.
US Subsidiary
Corp. Corp.
Offshore SPV
Bank
Source: Source: Deutsche Bank
The bond with warrants structure has no real implications for investors and
these instruments should simply be valued as normal convertibles.
Different subsidiaries
wish to issue the
different components
within the convertible
Coupon changes
An increasingly common feature of the fixed-income universe (particularly
prevalent among telecom names) is the step up coupon. Here, the interest
rate that an investor receives is increased on set dates or under specified
events, or a bond may change from a zero-coupon accreting structure to an
interest-bearing instrument. This feature has rarely been used among
convertibles, but its increasing appearance in the fixed-income universe
suggests that convertible investors should be aware of it.
Telewest 11.375% 2010 USD is a good example of a straight bond that
converts from an accreting structure to an interest-bearing instrument. The
bond was issued in 2000 at a price of 57.406 and accretes up until February
2005, after which the bond pays a semi-annual coupon of 11.375%, though
the bond also becomes callable on the same date. This structure is highly
suited to a growth company, avoiding cash outflows until the business
matures and starts to generate revenue. The call allows the company to
refinance and saves it from paying high interest rates after the business has
matured.
Bonds with step-up coupons dependent upon ratings downgrades have
become particularly popular among telecom issuers following their inclusion
by Olivetti in the debt issued to finance its acquisition of Telecom Italia. The
idea is very simply to protect investors in high credit quality issuers that are
using the balance sheet to fund acquisitions (or in the case of some of the
other Telcos, investment in 3G licenses). The basic concept is that if the credit
rating as assigned by Moodys or S&P declines to a specified level, the
coupon rate of the bond increases, enhancing the return to the investor.
However, the problem is that if these clauses appear in a majority of an
individual companys debt, they can increase the volatility of ratings. This is
because if a downgrade occurs, the interest charge will increase, damaging
the interest cover ratios and making a further downgrade more likely. And of
course, if a further downgrade does occur, this may well trigger further a
step-up clause, further weakening the interest cover, putting the rating under
further downward pressure. The problem for convertible investors is that
often their bonds do not contain the step-up clauses and so they have the
increased risk of downgrades without receiving the benefit of the coupon
enhancements.
One area where coupon changes have occurred within the convertible market
involves changing the coupon structure of the convertible to gain extra equity
credit. This is feature is far from common, but does occur in a number of
bonds and the recent $1 billion Swiss Re 3.25% USD 2021 provides a good
example. Here, for the first ten years of the 20-year structure, the bond
behaves like a normal convertible, but after ten years, the conversion rights
lapse and the bond switches to a callable FRN with an interest rate of LIBOR
+180. The bond should receive some equity credit from rating agencies due
to its long maturity, coupon deferral features and subordinated status.
Step-up coupons are an
increasingly common
feature of the fixed-
income universe
Step-up coupons can
increase the volatility of
ratings
Figure 33: Structure of Swiss Re 3.25% convertible
Soft call
with 120%
trigger
Year 10 Year 20 Year 5
Hard call
FRN
(Libor + 180 bps)
Fixed CB
(3.25%)
Source: Swiss Re 3.25%2011 USD Bond Prospectus, Deutsche Bank
This structure is far from ideal from an investor standpoint and hedging the
credit can be particularly difficult. The best hedge would be to asset swap the
bond on a callable basis (but with the investors ability to recall the bond
lapsing after conversion rights expire). However, while some asset swaps
have been undertaken in this name, the market is limited. The only alternative
hedge would be to buy ten-year CDS protection against subordinated Swiss
Re paper, but this would obviously leave residual credit risk with the investor
in the event that the bond does not convert or is not called. Effectively, the
investor is short a credit option struck at 180 bps over LIBOR. Consequently,
the asset swap level gives the best theoretical spread to use when evaluating
this bond.
Credit enhancements/repackaging of bonds
Obviously, one of the key criteria in valuing a convertible is the credit spread
of the issuer. When the issuer is unknown in terms of public debt, investors
often assume the worst about the companys credit and this will affect the
pricing that the issuer can achieve. However, it may prove that the issuing
bank and/or some of its fixed-income clients, or a selection of the companys
corporate banks, have a greater understanding than the wider market and
therefore believe that the debt should be priced more keenly.
Where this is the case, the convertible issue can be repackaged and then sold
as an exchangeable. The issuing bank either retains the original credit
exposure (at the price it feels is appropriate) or offsets the risk to a syndicate
of other banks or selected fixed-income investors. This works well for all
parties concerned. The investors can invest in a convertible with a credit they
know well, the issuing banks successfully sell the deal with the issuing
companys credit placed with the right group of investors and from the
companys perspective, the convertible is sold and keener pricing is achieved.
A good example of this in practice is the DB/Prada 1.5% Euro CORE bond.
Here, the seller of the underlying securities had no public debt and so the
right credit spread was not particularly well known in the market.
Consequently, the bond was repackaged and sold as an exchangeable with
Deutsche Bank credit.
Figure 34: Repackaged bond
Syndication of risk
Public
Convertible
Corp.
Fee
Exchangeable
Cash
Risk Fee
Bank
Numerous Asian issues have launched deals with enhanced credit, often
through a letter of credit issued by a bank. This is not an explicit guarantee,
but effectively acts like an implicit guarantee. The bank will presumably
account for the letter of credit as a contingent liability, but can always
syndicate out the risk, should they choose to do so. The mechanism for
receiving payment if the issuer goes into receivership is slightly different
from with an explicit guarantee, but in essence, the credit still becomes that
of the bank that writes the letter of credit.
Letters of credit work well and these issues are raised to the rating of the
guaranteeing bank. The credit derivatives markets apply a small haircut to
these structures due to the unusual nature of the documentation, but in
practice, there is little difference between these bonds and bonds that have
been repackaged as exchangeables. In both cases, the risk is transferred from
The issuing bank either
retains the original
credit exposure (at the
price it feels is
appropriate) or offsets
the risk to a syndicate
of other banks
the investor to the bank (and of course in both cases, the bank will charge a
fee for this), but with the exchangeable structure, the bank takes the issuers
risk on balance sheet
Figure 35: Letter-of-credit structure
Syndication
Public Corp.
Fee
Letter of
credit
Cash
Risk Fee
Bank
Bonds
Finally, some bonds are repackaged despite the issuers having exceptionally
strong credits. This is because it is necessary for other elements of the issue
and the PECs structure is an excellent example, though it is possible that
Turbo bonds could be sold as exchangeables as well.
Event puts
Conditional puts are becoming more common in issues, with the majority
being poison puts, which allow investors to demand early redemption in the
event of a takeover. However, there are some other examples of conditional
puts, often in industries where an operating licence needs to be granted by
the government. Here, the put is designed to protect the investor, for example
from political interference. Sometimes these puts have secondary conditions
and, in particular, many puts require that the specified event leads to a credit
downgrade (often to below investment grade); this greatly alters the dynamic
of how these puts operate.
Poison puts are particularly common in the US. In theory, they guarantee that
an investor will get at least the higher of parity and par (or accreted value) in
the event of a change of control, though, of course, enhanced conversion
rights or an increased offer from the acquirer can raise the investors returns
even higher. In some countries (for example the UK), market convention is
that an acquirer should offer at least par and where this is the case, the
poison put would seem to offer little value. However, market conventions are
often non-statutory and therefore poison puts are still advantageous, even in
these markets.
Poison puts seem to be an excellent protection for investors and indeed this
is normally the case. However, there is one problem with poison puts the
potential acquirer will know of their existence and the cost will be factored
into the evaluation of whether an acquisition makes sense. Obviously, if the
poison put is only in one convertible bond, its impact will be limited, but
often the provision will be in all public debt, and this is especially true for
second-line issuers. Clearly, in this case, not only will the cost of the
acquisition greatly increase, but also any acquirer will have to finance any
acquisition predominantly in cash. This can be a severe handicap to
necessary restructuring and consequently can prevent companies being taken
out if the shares perform badly.
Some of the alternative Telcos in Europe illustrate this very well. For
example, the Versatel convertibles contain good poison put protection, but
unfortunately so does all of the companys straight debt. The equity has fallen
so far that a cash bid of Euro 100m would represent an enormous premium to
the current price. However, the cash cost of redeeming all of the bonds would
be more than Euro 1.6bn and clearly this will make any potential acquirer
think twice about launching a takeover. Another good example of this is the
UK cable industry, where poison puts in the debt of the various companies
put severe hurdles in place, despite the industrial logic of further
consolidation.
Some convertibles (and most commonly those issued by privatised and
regulated UK corporates) contain regulatory puts. These allow investors to
require the company to redeem the bonds early, but the puts only become
active following certain pre-defined triggers. These normally relate to
changes to the operating franchise of the company, often coupled with
ratings downgrades to below investment grade. These regulatory puts have
traditionally been seen as a support to the credit. In particular, these
regulatory puts have highlighted the connections between the issuer and the
government, reinforcing the argument (false in our view) that there is implicit
government backing for these names.
Poison puts provide
protection, but can
prevent restructuring
Some of the privatised
UK corporates have
issued convertibles with
regulatory puts
The idea of implicit government credit backing has become increasingly
questioned over the last year, as demonstrated by significantly widening
spreads at many privatised companies. Nevertheless, the regulatory put
feature would seem to offer some protection to investors. However, we
believe this protection is limited at best. Companies with regulatory
dependant puts are by definition subject to significant regulation, which is
likely to alter the administrative process compared to normal corporate
entities. This is likely to restrict bondholders if the company goes into
administration and may well prevent bondholders from exercising the put
should it be triggered. Investors should be aware that all straight bonds
issued by the company are likely to contain similar restructuring puts and as
with poison puts, this restricts their value. Consequently, we believe investors
should attach little, if any value to regulatory puts.
Unusual call structures
Legal or regulatory calls can be used in certain cases where the issuer needs
additional flexibility, for example, where corporate activity has almost, but
not quite, completed. The Rhone Poulenc exchangeable into Rhodia provides
a good example of this; the bond was sold ahead of completion of the deal
with Hoechst, but was redeemable with a 2% penalty if the Aventis merger
did not complete. This certainly represented a risk to investors, but as there
were no real obstacles to the merger, this was seen as minimal.
A better precedent from the investors perspective is the call used in the
DB/Novartis structure. As this transaction was driven by the tax benefits to
the issuer, Novartis naturally wanted to protect itself against any adverse
regulatory changes. However, allowing the bonds to simply be callable would
effectively remove all the optionality from the investor. Consequently, there is
a call structured within the bond that allows the issuer to redeem at the
higher of the accreted value and the market value giving the investor full
protection in the unlikely event that this call is activated. Obviously, future
issuers may want to include this clause to give increased flexibility. Where
there is greater risk of this call feature becoming active (ie, where the
triggering event is more likely), we would expect investors to demand a
modest premium to be included within the clause.
DB/Novartis regulatory change call clause
Redemption upon Legal or Regulatory Change. The Issuer may, upon not less
than 30 Banking Days notice in accordance with 9,redeem all, but not less than
all, of the Bonds then outstanding at the greater of (i) the current market price of
the Bonds, as determined jointly by two independent investment banks of
international reputation selected by the Issuer and (ii) the Accreted Principal
Amount (determined as set forth in 2(4)),if any change or prospective change in
the accounting, tax, legal or regulatory treatment applicable to the Bonds, the
Shares or any hedging transaction of the Issuer, the Guarantor (as defined in 6)
or any affiliate of the Guarantor in respect of the Bonds (including, among other
things, any derivatives transaction entered into by the Issuer, the Guarantor or
any affiliate of the Guarantor with a third party with respect to the Shares)has
occurred or is likely to occur that would have a material adverse effect on the
Issuer s or the Guarantor s position in respect of the Bonds or the position of
the Issuer, the Guarantor, any affiliate of the Guarantor or any counterparty in
respect of any such hedging transaction, in each case as determined by the
Issuer in its fair discretion (315 German Civil Code), provided, however, that the
Issuer may exercise such right of redemption (x) only after having used
reasonable efforts to avoid such a material adverse effect (including, among
other things, by restructuring any hedging transaction of the Issuer, the
Guarantor or any affiliate of the Guarantor),and (y) in the case of a prospective
change, not earlier than 90 days prior to the effective date of such prospective
change.
Source: DB/Novartis 0% 2010 Euro Bond Prospectus
Tax calls were a very common feature until the late 1990s, in particular within
Europe, allowing the issuer to redeem the bond early in the event of
unfavourable tax changes. These often related to withholding tax, as many
issuers had contracted to make good any loss to international investors if
withholding tax were imposed upon their bonds. Tax calls were introduced to
give the opportunity to the issuer to refinance if withholding tax increased the
cost of their bonds. Unfortunately for some issues, the loss of optionality due
to the bonds becoming callable was more negative than the effective coupon
reduction through the imposition of withholding tax, especially for lower
coupon bonds issued in the more recent lower interest-rate environment.
Consequently, when the EU started to seriously consider the imposition of
withholding tax on eurobonds, this issue became a real concern within the
European convertible market. However, the UK appears to have successfully
stalled progress on the withholding tax debate and, in any case, the argument
for existing bonds to be grandfathered (ie, excluded from any new
withholding tax regulations) seems to have been won. In addition, almost all
European issues over the last three years have no tax call provisions included
and consequently the concerns within the European market have receded and
seem unlikely to return. Tax calls do exist in some other jurisdictions (eg,
Asia), though the risk of them being triggered seems minimal.
Disclosure checklist (priced as at 26 February 2002)
Company Ticker Price Disclosure
Ahold AHLN.AS Euro 27.27
AXA AXAF.PA Euro 21.13
Credit Swiss CSGZn.VX CHF 59.65
Daimler Chrysler DCXGn.DE Euro 46.17 1,5,6,8
Deutsche Bank DBKGn.DE Euro 67.01
Energis EGS.L GBp 3.44 2
France Telecom FTE.PA Euro 29.45 1
KBC KBKBt.BR Euro 35
KPN KPN.AS Euro 5.67 8
Merrill Lynch MER.N $48.5 2
National Grid NGG.L Euro 465.5
Nestle NESZn.VX CHF 375.5
Novartis NOVZn.VX CHF 62.85 1
Panafon PANr.AT Euro 5.76 2
Prada na na
Railtrack na na 1,2
Roche ROCZg.VX CHF 117
Swiss Re RUKZn.VX CHF 148 1
Telecom Italia TIT.MI Euro 9.26
Telewest TWT.L GBp 18.5 2
United Business Media UBM.L GBp 557.5 2
US Cellular USM.MU Euro 45
Versatel VERS.AS Euro 0.55
Vivendi Environment VIE.PA Euro 36.69 1
1. Within the past three years Deutsche Bank and/or its affiliate(s) has underwritten, managed
or co-managed a public offering for this company, for which it received fees.
2. Deutsche Bank and/or its affiliate(s) makes a market in securities issued by this company.
3. Deutsche Bank and/or its affiliate(s) acts as a corporate broker or sponsor to this company.
4. The author of or an individual who assisted in the preparation of this report (or a member of
his/her household) has a direct ownership position in securities issued by this company.
5. An employee of Deutsche Bank and/or its affiliate(s) serves on the board of directors of this
company.
6. Deutsche Bank and/or its affiliate(s) owns an amount of securities issued by this company
that is reportable under the ownership reporting rules of a jurisdiction in which this
companys securities are registered or listed.
7. Deutsche Bank and/or its affiliate(s) is providing, or within the previous 12 months may have
provided, investment services or other advice to this company.
8. Deutsche Bank AG and/or one of its affiliates are advising KPN NV, Netherlands on the
proposed sale of its 44.66% stake in Pannon, Hungary to Telenor ASA, Norway
As of December 31, 2000, Deutsche Bank AG (DBAG) beneficially owns 14.2% of
DaimlerChrysler AG, as filed with the U.S. SEC on Schedule 13G. In addition, DBAG served
as Financial Advisor to Daimler-Benz AGs merger with Chrysler Corporation and was an
underwriter for Daimler-Benz AG within the last three years.
The information and opinions in this report were prepared by Deutsche Bank AG or one of its
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public. The information herein is believed by Deutsche Bank to be reliable and has been
obtained from sources believed to be reliable, but Deutsche Bank makes no representation as to
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provide investment banking services for those companies. In addition, Deutsche Bank or its
respective officers, directors and employees hold or may hold long or short positions in the
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The financial instruments discussed in this report may not be suitable for all investors and
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currency, a change in exchange rates may adversely affect the price or value of, or the income
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past performance is not necessarily indicative of future results.
Unless governing law permits otherwise, all transactions should be executed through the
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Copyright 2002 Deutsche Bank AG, all rights reserved.
2002EUR05089
Additional information available upon request

GLCAL CCNVFPTILFS GPCUP

Head oI Convertib|es 44 20 7545 2385
Nicho|as Nie|| (MD)

Head oI Sa|es 44 20 7545 2360
Peter Darre|| (MD)

LCNDCN PAPIS NFW YCPK
Int. Pesearcb 44 20 7545 2361 Sa|es 33 1 44 95 64 00 Pesearcb 1 212 469 5301
Michae| O'Connor Laurent Lepinay Jeremy Hovard
Frank Kennedy Jean-Pasca| Meyre Jonathan Cohen
C|odagh Mu|doon Laurent P|uchard Jonathan Poo|e

Sa|es 44 20 7545 2360 FPANKFUPT Sa|es 1 212 469 5968
Pob Saunders Sa|es 49 69 910 30993 Sean Peyno|ds (MD)
Tom Wiggin Pichard Knoche Po Bava
Tony Shober David Ca|zo|ano
Diego Farneti TCKYC Marco Depero
Simon Shepherd Sa|es 81 3 5156 6780 Mark Fdgar
Pobert Bres|in Pau| McMahon
Trad|ng 44 20 7545 2385 Fijiro Fukui Kenneth Ne|son
Nick Conington (MD) Atsuko Daibo Adam Posnack
Steve Poth (MD)
Andy McDonne|| Trad|ng 81 3 5156 6773 Trad|ng 1 212 469 5968
Simon Carcia Toshiya Yoshioka Dave Hammond
Christopher Huggins Purav Asher Michae| Cunner
Harprit La||y Yukio lzava lan Jaycock
Chris Seve||
C Asset Swas 44 20 7545 2365 HCNG KCNG Michae| Tarro
Ju|ian Moore Sa|es 852 2203 6899
Jeremy Hughes Kevin Koo
Pita Kong
Pesearcb Tecb 44 20 7545 2362
Pichard Forss Trad|ng 852 2203 6899
James Covan Lee Partridge

Convertible Structures
March 2002
Michael OConnor
Head of International
Convertible Research
+44 20 7545 2361
moc@db.com
Frank Kennedy
+44 20 7545 2361
frank.kennedy@db.com
Clodagh Muldoon
+44 20 7545 2361
clodagh.muldoon@db.com
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