The mass of convertible debt that got brought to market in the last two years may be coming home to roost.

Companies have been issuing so-called converts, or bonds that turn into stock at a predetermined price, as never before. After growing by 45% in 2000, convertible issuance doubled last year, reaching $102 billion. With the stock market sputtering and lenders turning conservative, converts enticed issuers by dangling a juicy stock payout -- down the road, meaning the deals weren't immediately dilutive to shareholders.

But with the economy stagnant and the tech-spending bubble long deflated, debt of all kinds has become a losing proposition. In the wake of the failures of debt-heavy Enron and Global Crossing, risk-averse stock and bond investors have been distancing themselves from practically any company with big interest payments ahead; even seemingly solid companies, including Sprint, are facing the prospect of being shut out of the market for low-cost short-term commercial paper financing.

Many of the companies that issued converts last year were risky propositions that have lately fallen on hard times. As a result, some convertible investors have suffered -- losses in the convert market recently forced two hedge funds run by Kenneth Lipper to cut their portfolios' value by about $315 million, according to The Wall Street Journal.

Those losses could damage the issuers as well: Many of the companies that brought convertible bonds to market last year agreed to unusually aggressive terms that give investors the right to sell the bonds back to the companies if the underlying stock doesn't perform well. In many cases the company has the option of issuing more stock rather than paying cash, but issuers worry that doing so can flood the market, further depressing their shares. The upshot is that a device companies used only a year or two ago to raise cash now threatens to drain their coffers just as greenbacks grow scarce.

Rust Belt?

The company that's had the worst problem with convertibles lately is Tyco ( TYC). Tyco has issued some $7.7 billion in so-called zero-coupon convertibles, which give investors the right to sell the bond back to the company, or "put" it, at certain times.


Shiny New Convertibles
Convertible debt issuance on the rise ($billions)
Source: Thomson Securities Data

Even though its zero-coupon converts don't start to become putable until next year, the slide in Tyco's stock and worries about its bookkeeping have unnerved convertible investors. As a hedge, many funds that owned Tyco's converts had shorted the stock to limit risk. Typically a fund that had made this hedge would cover the short as Tyco's convert fell through the price at which it was putable.

But convertible holders became concerned about Tyco's credit quality as its stock and bonds slid and accounting rumors swirled. Damaged credit quality would make it harder for Tyco to raise the cash it would need if investors put its converts to it. To hedge against this possibility, according to ABN Amro convertible analyst Richard Nelson, funds that held Tyco converts shorted even more Tyco. That sent Tyco's stock down even further.

Tyco may have had the biggest headache with its converts, but it certainly isn't alone. According to ConvertBond.com, Cox Enterprises, the majority investor in Cox Communications ( COX), got $454.5 million worth of a convertible issue -- some 99% of the outstanding bonds -- put back to it on Feb. 15. Cox Communications has an additional convert with a put date today; Cox said Tuesday it would toss some extra cash to investors who continue to hold past the put date. Cox shares, already down 23% this year, slid 3%. The company's cash position appears sound. But even in the best-case scenario, in which all the convertible investors take it up on its offer, it will have around $13 million less to play with.

New Era?

Cox's convertible, brought to market a year ago, was one of a new breed. Whereas in the past, put dates on convertibles typically came along several years after issuance, in 2001, explains Advent Capital Management portfolio manager Barry Nelson, many issuers opted to have a put date after the first year. In many cases the bonds also offered extremely high conversion yields. So if a company's stock didn't perform well, it risked having its convert put back to it in short order. Cox didn't return calls for comment by publication time.

"I'm surprised companies made such big bets on their stocks going up," says Nelson. "It's as though issuers thought the euphoria in the stock market would return."

A number of converts look like they could get cashed in on their put dates over the coming months. Janus parent Stilwell Financial's ( SV) zero-coupon convert issued April last year was structured in a way that if its stock didn't rise significantly over the next 12 months, investors could easily justify putting the convert back to it. Stilwell's stock has fallen 20% since then, and the company could be on the hook for up to $697 million worth of cash or stock come April 30. A Stilwell spokeswoman says the company expects to the have cash and credit facilities in place to pay investors if its convert gets put to it. The company may also consider other options, like Cox did, as the put date appoaches.

In similar straits, hotelier Marriott ( MAR) has seen its stock fall 19% since it issued its convert in April last year. It could have $411 million put to it May 5. The stock of semiconductor equipment maker Novellus Systems ( NVLS) has dropped 15% since it issued its convert last July. It could get put to the tune of $862 million. Neither company returned calls for comment by publication time.

As with Cox, such companies will work to find some way to manage. Calpine ( CPN), for example, sold $1 billion in new convertible debt in December, partly so it could buy back some of the mass of converts that will likely get put back to it April 30. And while both Cox and Calpine were able to steer away from trouble, it's clear that the underwater convertibles became just one more hazard to deal with.

These days, that's another hazard companies don't need.

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