-----Original Message-----
From: 	Herndon, Rogers  
Sent:	Thursday, November 15, 2001 9:05 AM
To:	Presto, Kevin M.; Sturm, Fletcher J.
Subject:	FW: rh

Interesting article below about Calpine and others' 0 coupon convertible bonds with put options - due April '02.  This is ugly.

RH

 
 
 
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Fortune  
November 26, 2001 
SECTION: FEATURES/TOXIC BONDS; Pg. 131 
LENGTH:  2242 words 
HEADLINE: Headed For A Fall; 
Companies issued special  zero-coupon bonds, assuming they'd never have to
pay them off. Now  shareholders could be on the hook for a $ 65 billion tab. 
BYLINE: Janice  Revell 
BODY: 
It was an irresistible proposition: Borrow  billions of dollars, 
pay no interest, reap millions in tax breaks, and then  wait for 
the debt to simply disappear. That was the promise of  
zero-coupon convertible bonds, and companies from Enron to 
Merrill Lynch  binged on what seemed like free money. 
But, of course, there was a  catch: For this scenario to play out, 
a company's stock price had to rise  sharply--and quickly. That's 
because investors bought the bonds in the hope  of converting them 
into equity--if the stock tanked, the bonds would no  longer be 
worth converting. So to make them more attractive to buyers,  
companies had to build in an escape hatch: If the stock price 
failed to  rise sufficiently, investors could "put" (that is, 
sell) the bonds back to  the company--in many cases, after just one 
year. 
And that's exactly  what's about to happen--to the tune of some 
$ 65 billion over the next three  years. Stock prices have fallen 
so far that for at least half of these  special hybrids, the 
prospect of conversion is now absurd. It simply won't  happen. So 
bondholders are looking to get their money back the first chance  
they can. And because of the put feature, that is possible. 
Suddenly  companies like Tyco, Comcast, and dozens more are on 
the hook for billions  of dollars in debt and interest they 
thought they'd never have to pay.  
That could be very bad news for shareholders of these companies.  
After all, they're the ones who are going to be picking up the 
tab when  all that debt comes due. Huge chunks of cash will 
disappear from balance  sheets to repay bondholders. Companies 
without enough cash--and the majority  fall into this camp--are 
likely to face skyrocketing interest charges when  they borrow 
money anew. That means sharply reduced earnings. Especially at  
risk are investors in companies with poor credit ratings--prime  
candidates for killer refinancing costs. Some companies may even 
be  forced to issue stock to pay off the debt, creating 
significant shareholder  dilution, especially at current 
depressed prices. To make matters worse,  this is happening at a 
time when the economy is barreling downhill and  corporate 
profits are already shrinking. "This is a ticking time bomb,"  
warns Margaret Patel, manager of the Pioneer High Yield Bond 
fund, a  top-performing junk fund. 
The seeds of this mess were sown in mid-2000,  when the stock 
market started to falter. Companies in search of capital  balked 
at the thought of selling stock while their share prices were  
struggling. Zero-coupon convertible bonds presented an 
attractive  alternative because companies didn't have to make 
cash interest payments on  the bonds (hence the name "zero"). 
Instead issuers offered an up-front  discount--for instance, 
investors would buy a bond for $ 700 and collect $  1,000 when it 
matured. 
Companies also gave investors the right to  convert the bonds 
into a fixed number of common shares. But the bonds were  
structured so that conversion would make sense only if the stock 
price  rose significantly--in many cases, by more than 50%. With 
that protective  feature (called the conversion premium), zeros 
took off. Corporate issuers  would pay no interest, and once 
their stock prices had climbed back to  acceptable levels, the 
debt would be swept away into equity. "If the bonds  are 
converted, it's a home run for everybody," says Jonathan Cohen, 
vice  president of convertible-bond analysis at Deutsche Bank. 
That  four-bagger, of course, depends entirely on the stock price 
rising. If it  doesn't, the bondholders, armed with that handy 
put feature, can simply sell  the bonds back to the company. 
Great for bondholders, but not so hot for the  company or its 
shareholders. But, hey, what are the odds of that happening?  
"CFOs and CEOs believe that their stock will just continue to go 
up,"  says Cohen. "They don't worry about the bond getting put." 
If all this  seems a little complicated, that's because it is. A 
real-life example should  help. California-based electric utility 
Calpine issued $ 1 billion in zeros  in April to refinance 
existing debt. At the time, the company's stock was  trading at 
about $ 55 a share--severely undervalued in the opinion of  
company management. "We really didn't want to sell equity at 
that  point," says Bob Kelly, Calpine's senior vice president of 
finance. So the  company instead opted to sell zeros, setting the 
conversion premium at a  hefty 37%. 
Still, with no cash interest payments and a stock price that  had 
to rise significantly to make conversion worthwhile, the bonds  
weren't exactly a screaming buy for investors. So Calpine added 
the put  feature: Investors could sell the bonds back to the 
company after one year  at the full purchase price, eliminating 
any downside risk. 
Things  haven't exactly worked out as management had hoped. The 
stock has since  plummeted to $ 25, and it now has to triple 
before conversion makes sense.  So it's looking as though Calpine 
will be liable for the $ 1 billion in  borrowed money when 
investors get the chance to put the bonds this April.  There's 
also the refinancing cost. According to Kelly, Calpine's  
borrowing rate could run in the neighborhood of 8.5%--an extra 
$ 85  million per year in cash. "Obviously, nobody plans for their 
stock to go  down," Kelly says. "I don't think there was one 
person around who thought  the bond would be put." 
Calpine's potential costs are particularly high  because its 
credit rating is straddling junk. "If you are a borderline  
investment-grade company, a financing of this nature is not 
necessarily  the most appropriate thing in the world," notes 
Anand Iyer, head of global  convertible research at Morgan 
Stanley. The problem is, there are a slew of  companies with far 
worse credit ratings out there: Jeff Seidel, Credit  Suisse First 
Boston's head of convertible-bond research, estimates that  about 
half of all zeros outstanding fall into the junk category. And  
others are at risk of having their ratings downgraded before the 
put  date. Today, with junk yielding as much as 5 1/2 percentage 
points above  bonds rated investment grade, refinancing can be a 
pricey proposition.  
Contract manufacturer Solectron is one that could well get hit 
by  the high price of junk. It has $ 845 million in zeros that it 
will probably  have to buy back this January, and another $ 4.2 
billion coming down the  pike over the next couple of years. 
Because of slower-than-expected sales,  the company was recently 
put on negative credit watch by three rating  agencies. And if 
Solectron's credit is downgraded, the zeros would slide  into 
junk status, a situation that could cost the company--and its  
shareholders--tens of millions of dollars in refinancing charges.  
Refinancing isn't the only worrisome cost associated with these  
zeros. Companies pay hefty investment banking fees to sell their  
bonds--up to 3% of the amount raised. If the debt is sold back, 
many  will have spent millions for what essentially amounted to a 
one-year loan.  "They're getting bad advice," claims one banker 
who didn't want to be named.  "Look at the fee the banker earned 
and look at the kind of financing risk  the company got into." 
As if those potential consequences were not scary  enough, 
shareholders can also get whacked when the bonds are first  
issued. That's because some 40% are bought by hedge funds, which 
short  the company's stock (sell borrowed shares with the 
intention of buying them  back at a lower price) at the same time 
that they buy the bonds. If the  stock goes down, the shorts make 
money from their position. If it goes up,  they profit by 
converting the bond to stock. This hedging strategy almost  
always causes the stock to plummet, at least for a while. 
Grocery chain  Supervalu, for example, recently lost 10% of its 
market cap the day it  announced it was issuing $ 185 million in 
zeros. 
Despite all the  pitfalls, the love affair with such Pollyanna 
bonds continues, thanks in  large part to the slick tax and 
accounting loopholes they provide. In fact,  the hit on earnings 
per share can be the lowest of any form of financing.  Even 
better, thanks to a wrinkle in the tax code, companies can rake 
in  huge tax savings by deducting far more interest than they're 
actually  paying. All they have to do is agree to pay small 
amounts of interest if  certain conditions prevail. Verizon 
Communications, for instance, would pay  0.25% annual interest on 
its $ 3 billion in zero bonds if its stock price  falls below 60% 
of the issue's conversion price. In the eyes of the IRS,  oddly, 
that clause enables the company to take a yearly interest  
deduction, for tax purposes, of 7.5%--the same rate it pays on 
its  regular debt. (Why? Trust us, you don't want to know.) That 
adds up to an  annual deduction of more than $ 200 million, even 
if Verizon never shells  out a dime in interest. Not 
surprisingly, more than half of the zeros issued  in 2001 contain 
similar clauses. "It's an incredible deal for them," says  Vadim 
Iosilevich, who runs a hedge fund at Alexandra Investment  
Management. "Not only are they raising cheap money, they're also 
doing  tax arbitrage." 
So despite the enormous risks to shareholders, companies  
continue to issue zeros at a steady clip: According to 
ConvertBond.com,  seven new issues, totaling $ 3.5 billion, have 
been sold since Oct. 1 alone.  "I think the power of the tax 
advantage is going to keep them around," says  CSFB's Seidel. 
Call it greed or just blind optimism that the markets will  
recover quickly--it doesn't really matter. Either way, it's the  
shareholders who'll be left paying the bill.