“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.
As rates dropped to near-zero in 2021 and the volatility of speculative and high-growth companies blew out, it created the perfect environment for zero-coupon convertible issuance. A raft of issuers did just that. Per Bloomberg, "The mania was such that $58 billion of the securities were issued in 2021, an increase of almost 1,100% from two years earlier."
In mid-2021 the 5-year US Treasury yield hovered around 1% and many of these bonds came to market close to, or above, par. Like Yahoo’s offering over two decades ago, investors' return depended entirely on the equity call option being in-the-money to generate a return. For many, it is not.
Everything is equity.
Rising rates and wider credit spreads have hit both the straight bond value of these convertibles and the underlying equity. Whereas the option represented a significant portion of the value of these bonds at issuance, that premium has shrunk or disappeared altogether. With coupon out of the picture, duration equals maturity. All that is left is a deep out-of-money call option, credit risk and convexity. Yet, with the exception of Beyond Meat, many trade above 70 cents on the dollar, and spreads for most are in-line with AAA-rated corporate issues. The Airbnb convertibles, with a strike price now 230% out of the money, trade at a tight 83 basis points to treasuries.
What did these instruments represent at issuance and what do they represent now? Then and now, they are an implicit bet on the equity value of the company. When rates were at their nadir and fixed income did not pay these bonds offered a way for fixed income managers to sneak equity-like upside into their portfolios while still technically checking the "Bond" box. Today they are bets on the ability of these companies to access the capital markets to refinance this debt. Most of these bonds also benefit from getting paid off at par in the event that an issuer gets acquired. Are these explicitly credit or rate considerations? No, they are merely related; the outcome of these bonds will continue to be a function of the performance of the issuer's equity.
“Given that Warren Buffett is selling something, should I really be buying?”
In 2002, a year before Yahoo’s offering, Berkshire Hathaway broke new ground issuing a negative yielding convertible bond. The issue designed by Goldman Sachs and given the moniker “SQUARZ1” carried a 3% coupon along with a warrant to purchase Berkshire shares at a 15% premium. However, to keep the warrant active investors would have to pay Berkshire 3.75% annually creating a negative yield of 75 basis points. Ted Southworth, then manager of the Northern Income Equity Fund asked Reuters at the time, “Given that Warren Buffett is selling something, should I really be buying?”
An uptick in the issuance of zero-coupon convertibles almost always means markets have "lost the thread" on capital allocation. For investors it is not entirely clear what the zero-coupon convertible offers. The option value is almost always available without committing the capital to the bond portion of the instrument. A favorite, oft cited Jim Grant quote in this publication is,
Needing income, investors will take imprudent risks to get it. And if 2% invites trouble, zero percent almost demands it.
Berkshires negative yield convertible was popular and sold quickly to institutional investors. The original offering was upsized to $400 million from $250 million. The New York Times wrote,
The securities were sold only to institutional investors in a private placement, but Berkshire did not take any risk that the buyers would be unable to pay the future warrant premiums. Buyers paid $10,340 for each $10,000 bond, with the extra $340 going to pay for zero-coupon Treasuries that will pay the extra 0.75 percent each year.
Everything really is a bond and calling zero-coupon convertibles “bonds” is a little like calling an El Camino a truck. It has the features, but very little of the function for investors.
Further,
For a more quantitative review of zero-coupon convertibles and their use in corporate finance, The Footnotes Analyst has an excellent breakdown with an interactive calculator.
“Berkshire said the new securities are called Squarz (pronounced squares) but did not say just what those letters stood for. Investment banks love to copyright such names because they cannot protect financial structures from imitators if they prove to be popular.” Berkshire Hathaway Negative Coupon Bond Case Study (nyu.edu)
Hunter - this is one of the most gloriously magnificent and beautiful pieces of writing I’ve ever encountered. You live up to the standard set by Matt Levine. Please continue with this type of stuff. I need to marinate in every aspect of this article for some time. None of this is hyperbole. Thank you. JB