Sideswiped by Convertibles
For companies in search of cheap financing during the end of the '90s boom, convertible bonds seemed the closest thing to free money. These hybrid securities--in which bonds eventually can be converted into equity if a share-price target is hit--gave telecom and energy companies such as Lucent Technologies Inc. (LU ) and Calpine Corp. (CPN ) the best of all possible worlds. By issuing bonds that featured a large balloon payment of debt and accrued interest years later, companies still enjoyed huge tax breaks. What's more, the interest rates were far lower than on standard corporate bonds. Many companies didn't think they would ever have to repay the convertibles, since buyers snatched them up largely to parlay them into stocks at an attractive conversion price.
Now these securities are coming back to haunt their issuers. Because the shares of many highfliers--such as WorldCom Inc. (WCOM ) and Tyco International Ltd. (TYC )--are in sharp decline, most of the hundreds of billions in convertible bonds they issued are unlikely ever to be traded in for shares. As a result, convertible investors could force those companies to buy them back at their original value. Suddenly, convertibles are emerging as debt bombs for issuers.
According to Morgan Stanley Dean Witter & Co., over the next 18 months, nearly $30 billion in convertible securities issued by the likes of Anadarko Petroleum (APC ), Household International (HI ), and Medtronic (MDT ) could come due. Next year, Solectron Corp. (SLR ) alone could be on the hook for $2.5 billion, while Tyco may have to repay nearly $6 billion in convertibles. "I'm in a state of high anxiety," frets Margaret Patel, manager of the Pioneer High Yield Fund. If one or more of these companies can't meet their obligations, "investors will be spooked, as if they need any more spooking."
There is certainly cause for concern: The prospect of having to unexpectedly raise billions of dollars to repay bondholders is likely to cause a drag on the economy, too. Neal Soss, chief economist at Credit Suisse First Boston, believes that the growing heft of convertible debt repayments is contributing to the widening interest-rate spread between Treasury and corporate bond yields. That gap is the widest since the Great Depression.
What's more, Soss believes the bond repayments could stunt the recovery by diverting billions into debt service that companies could otherwise have spent on capital investments. "The risk now is that companies [will] spend this year and next still fixing their balance-sheet problems from the past," says Soss.
For their part, most of the issuing companies dismiss any concerns. Tyco's chief financial officer, Mark Schwartz, notes that the first of the company's two convertible payments due next February, for $2.3 billion, can be repaid in stock. But such a move would hardly be welcomed by Tyco's beleaguered investors, who would see their shares diluted by about 4%. While Schwartz acknowledges that the $3.5 billion due in November, 2003, "will have to be settled in cash," he says Tyco's cash flow should cover it. Still, analysts aren't convinced it can meet all its obligations. "It's far from a foregone conclusion that Tyco can pull [this] off," says Carol Levenson, research director for Gimme Credit, an institutional research service.
For now, convertible bond investors--many of whom are hedge-fund managers--are extracting pricey concessions in return for not forcing bond repayments. On Feb. 19, Atlanta cable giant Cox Communications Inc. (COX ) agreed to spend $13 million to give a special 1.7% payment to investors in the zero-coupon convertibles it issued last year. Otherwise, Cox would have had to repay bondholders the full $545 million it owed. Comcast Corp. (CMCSK ) was forced to make a similar agreement last December. "The market is not going to refinance the converts easily," says Ravi Malik, a money manager at Froley, Revy Investment in Los Angeles.
At the height of the boom, convertible bonds seemed like a kind of risk-free loan for many companies. But the market's decline is yet again proving that easy money often turns out to be the most expensive.
By Dean Foust in Atlanta, with Geoffrey Smith in Boston