The Zero-Coupon Convertible
Everything is a bond, actually everything is an option, actually everything is equity.
“The most beautiful thing that ever shouldered a load! It rides and handles like a convertible yet hauls and hustles like the workingest thing on wheels.”
- Chevrolet Motor Company
Everything is a bond.
The source of most investment returns can be condensed down to a combination of coupon, credit, duration and convexity. The distinction between debt and equity as an outside passive, minority shareholder (OPMI in Marty Whitman language) is largely legal, partially philosophical and practically non-existent. Will you get paid back, how much, when and how are the basic inputs of every investment. The structuring of financial instruments is really a practice of tweaking these inputs to solve for both company financing constraints and investor appetite.
The periodic resurgence of zero-coupon convertible bonds is a personal curiosity and a signal that the market's conception of the basic investment inputs has been distorted. Companies like this source of financing as a way to take advantage of inflated share prices that doesn't immediately dilute shareholders or strain leverage ratios with new debt service. In reality, the true cost of zero-coupon convertibles reflects their hybrid nature. When factoring in hedging costs and the future dilution, the cost of this form of capital tends to fall between debt and equity.
In the summer of 2003, Yahoo stock was up 47% year-to-date, while the US 10-Year Treasury yielded just above 3%. Yahoo issued $750m of 5-year zero coupon convertible bonds for general corporate purposes. Yahoo stock traded around $24 per share and bond holders would be able to convert into stock at $41 per share, a 68% premium to the share price at issuance. If bought at par, Yahoo shareholders would earn a 0% return unless the stock rose above $41. "Yahoo is getting an excellent deal," Jeremy Howard of Deutsche Bank told Bloomberg at the time.
At this point it may be of some value to explain why a non-convertible zero-coupon bond is not inherently an absurdity. Lest you maintain the provincial notion that debt is always accompanied by cash interest payments, the market for Zero Coupon US Treasuries is large and liquid.
Issued at a discount to par, Treasury Zeros expose investors to greater duration than a similarly dated Treasury that pays a coupon. These are good for investors who are tuning the duration of a portfolio, matching liabilities, or are particularly sensitive to the tax implications of regular interest payments. The yield on zeros is captured in the discount to par where the bonds are sold. A 5-year zero coupon with a par value of $100, might sell for $78.35, a 5% yield-to-maturity.
Everything is an option.
When a company layers in the conversion rights, they are selling two financial instruments in one: a straight bond and call option. For bonds with no coupon, the value of the option offsets the discount to par. As a CFO of a company with volatile shares, the zero-coupon convertible is almost irresistibly elegant as it monetizes the equity volatility in the form of a loan, the cost of which will be borne sometime in the future.
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