Convertible Bonds and the Bull Market

One threat to corporate earnings this year comes from a most unlikely place: contingent convertible bonds.

A host of companies, from Interpublic Group (IPG) to Watson Pharmaceuticals (WPI), could see earnings reduced by a significant amount this year, thanks to the dilutive effects of these so-called CoCos.

Contingent convertible bonds are similar to ordinary convertible bonds in that they have a strike price at which the investor can convert the bond into stock. The difference, however, is that CoCos can't be converted into stock until a contingency requirement is met. Some companies, for example, might require the stock to trade at 110% of the conversion price for 20 out of 30 trading days.

CoCo issuers are not required by the Financial Accounting Standards Board to include any of the dilutive impact from these bonds in the calculation of earnings per share until the contingency requirement is met, according to David Haushalter, a forensic accounting analyst at Susquehanna Financial Group. But with the stock market showing signs of life over the past year, an increasing number of these requirements are being met or are close to being attained.

Companies such as Interpublic, Cendant(CD), Yahoo! (YHOO) and Carnival(CCL) have already exceeded their contingent conversion prices, while Watson and Manor Care(HCR) are close to hitting their thresholds, Haushalter found in a recent study.

If these firms' CoCos were to be exercised, Watson would see earnings fall by more than 9% this year, while Interpublic would see earnings shaved by over 6%, Haushalter noted. Cendant would see a 3.5% reduction in profits, while earnings at Yahoo!, Manor Care and Carnival would be cut by more than 2.5%.

These numbers were derived by assuming that 100% of the convertibles are exchanged for stock and by adding after-tax interest payments from the bonds to the firm's earnings.