convertible structures

Convertible StructuresMarch 2002

Michael O’ConnorHead of InternationalConvertible Research+44 20 7545 [email protected]

Frank Kennedy+44 20 7545 [email protected]

Clodagh Muldoon+44 20 7545 [email protected]

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March 2002 Convertible Structures

International Convertibles 1

Introduction

The convertibles market has grown significantly since the early days, whenissuance was dominated by US railroad companies, and convertible bondsare now regarded as a global asset class, with circa $160bn of paper issuedlast year. The global capitalisation of the convertible market has reached over$500bn, despite the difficult equity markets. Continued growth in issuanceleads us to expect that this will continue to increase rapidly over the next fewyears.

Innovation has been one of the primary factors in this growth. Convertiblebonds have proved to be a highly efficient and flexible financing vehicle andas a result, greatly differing features and structures have been developed indifferent parts of the world. However, the trend towards increasingly rapidglobalisation has seen the faster adoption of structures from differentinternational markets. Consequently poorly explained ‘whistles and bells’ arecontinually being added to new bonds, while investors are generally givenless and less time to make investment decisions.

Many features and structures have now become commonplace, without a fullexplanation of their effects ever being given. We have attempted to describethe most common structures that occur within the convertibles market and toassess their implications for investors, in a bid to answer the most commonlyasked questions. Moreover, as the convertible market is driven by newissuance, we have attempted to explain the benefits of each of thesestructures to issuers, so that investors can assess which features are likely tobe more common going forward.

The convertible market is dynamic, responding, in particular, to tax andaccounting changes, and it would be impossible to cover every idiosyncrasyin existence. In this review, we have taken a look at some of the morecommon structures, how they affect investors and why companies use them.These structures are not mutually exclusive, but rather operate as a ‘mix-and-match’ menu for issuers, and it is often the combination rather than theindividual features that creates the complexity. Hopefully this guide will proveuseful in helping investors understand what issuers are trying to achieve,especially as innovation and globalisation mean that the pace of change islikely to remain high.

Convertible Structures March 2002

2 International Convertibles

Contents

Conversion features - macro ...........................................................3

Conversion features - micro ..........................................................16

Mandatory structures.....................................................................30

Zero-coupon bonds and accreting structures ..............................46

Convertibles and the balance sheet..............................................53

Other structures..............................................................................65



Conversion features – macro

1. Exchangeable bonds

2. OCEANE-style bonds

3. Cross-currency bonds

4. Pre-IPO convertibles

5. Chooser convertibles



Exchangeable bonds

Exchangeable bonds are an established feature of the convertible market,both from an issuer’s and an investor’s perspective, and can simply bedefined as a bond issued by one company which converts into the shares ofanother company. The advantages of the structure to the issuer (against anequity placing) are that the stake is potentially sold for a premium rather thanplaced at a discount and that any capital gains liability is at worst delayeduntil conversion and may even be avoided entirely.

Vanilla exchangeables are well understood and there is little for investors toconsider apart from the different credit profile compared to convertibles.However, some convertible bonds issued by subsidiaries (subsidiaryexchangeables) can lead to very different credit exposure for the investor.Finally, recent accountancy changes will greatly alter exchangeables from theissuer’s perspective and may result in significant structural changes toexchangeables.

One significant difference between convertibles and exchangeables is thetaxation implications for individual investors. In some jurisdictions,conversion of an exchangeable bond triggers capital gains tax for domesticinvestors, while conversion of a convertible does not. For these purposes,OCEANES and subsidiary convertibles usually count as convertibles.Investors should be aware of their tax liabilities with regard to conversion ofexchangeables and convertibles.

(Throughout this document, we have followed market convention and used‘convertible’ to mean either the overall asset class (including OCEANES andexchangeable bonds) or to mean specifically those bonds that are issued bythe company into which they convert. The specific use should be obvious bycontext and apologies if this is not the case).

Credit considerations

Exchangeable issuers tend to have far better credits than the underlyingcompanies into which they convert, particularly in Europe. However, thisneed not be the case and, anyhow, it is not the relative difference betweenthe credit quality of convertible and exchangeable issuers that we think needsconsideration. The key credit difference between a convertible and anexchangeable, in terms of credit, is that there may well be no or only limitedcorrelation between the stock price of the underlying shares and the issuer’scredit, especially if the issuer’s stake in the underlying represents only a smallpart of its NAV.

This can be positive for investors, in that if the underlying shares performpoorly, this will not necessarily lead to a deterioration in the issuer’s credit,and so the convertible’s bond floor will ‘hold’, thereby giving the investorbetter protection (see Figure 1). In Europe, this is particularly good news forinvestors, as the credit quality of exchangeable issuers is almost invariablyhigh investment grade.

Issuers sell equity

stakes for a premium

while delaying capital

gains tax liability

Stock-credit correlation

is the main difference

between convertibles

and exchangeables…

... low correlation is

generally positive given

the high credit quality

of European

exchangeable issuance



Figure 1: Relative credit correlation between a convertible and an exchangeable

Convertible

Telewest 5.25% 2007 GBP

30

50

70

90

110

130

150

170

Oct-99 Dec-99 Feb-00 Apr-00 Jun-00 Aug-00 Oct-00 Dec-00

Bond Price Parity

Strong stock/credit correlation - Telwests

credit spread widens out by 450 bps as

shares plummet

Exchangeable

Fr Tel / Panafon 4.125% 2004 Euro

45

55

65

75

85

95

105

115

125

135

Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01

Bond Price Parity

Weak stock/credit correlation of exchangeable -

despite France Telecom credit widening slightly,

bond floor remains high as underlying share

collapses

Source: Reuters, Deutsche Bank

However, the reverse is also true and an issuer’s credit can weaken even ifthe underlying shares perform well and, in the extreme, where default of theissuer looks likely, investors may be forced to convert early, possibly evenwhere the option is out of the money. (Receiving parity of 90% may give ahigher return in a default scenario than payout on the exchangeable as debt).

Indeed, this highlights another problem. Exchangeable bonds are very rarelysecured against the underlying shares and so if the issuer goes into default,investors will be treated equally to other creditors of the same rank, withoutnecessarily being given a chance to convert. Thus, for an unsecuredexchangeable with a parity of 150% where the issuer goes into default, theinvestor would be treated as an investor with a claim of 150% of the nominalvalue. This could be particularly painful for arbitrage investors, as the value oftheir short equity position would remain high, while the default payout on thebond would be substantially lower.

Exchangeable bonds are

rarely secured against

underlying shares…

… in default, the

investor has an

unsecured claim at the

higher of par and parity



The positive and negative credit aspects of exchangeables probably offseteach other and in the high credit universe of Europe, investors seriouslybenefit from this lack of credit/share-price correlation. Nevertheless, investorsshould be aware of the differing credit exposure given by exchangeables,particularly where there are restrictions on conversion, as this can increasethe risks.

Accountancy changes

The structure of exchangeable bonds will always be liable to change inresponse to changing tax or accountancy rules. Often, this will be invisibleand irrelevant to the investor, for example, changes to the structure of theSPV that issues the bonds. However, this is not always the case and investorsshould be aware that changes to exchangeable structures may be just asnecessary and important to exchangeable issuers as the CoCo and CoPaystructures have been to convertible issuers.

In particular, investors should be aware of the recent accountancy changesFAS 133 and IAS 39. In essence, these changes will force companies toaccount for their short-option position embedded in the exchangeablethrough the P&L account. Clearly, in reality, this would be more than offset bythe underlying equity holding, but these holdings are generally held inreserve accounts and therefore not run through the P&L. Consequently,adoption of this accounting practice would increase P&L volatility forexchangeable issuers, though the real impact and benefit atconversion/maturity would be the same. In reality, the issuer’s position hasnot changed and they are taking no additional risk! (Note: most majorcontinental European companies will adopt IAS by 2005 at the latest).

Nevertheless, corporates obviously want to avoid volatility of stated earnings,even if this could be excluded from normalised earnings. Consequently, weexpect to see some aspects of exchangeable structures alter to avoid theimplications of FAS 133 and IAS 39 and while much of this will be irrelevantand hidden from investors, there may well be cosmetic changes. However,we expect these to have minimal, if any impact on valuations.

Subsidiary ‘exchangeables’

Many bonds regarded as true ‘convertibles’ are technically exchangeable, asthe issuing entity is a subsidiary of the company into which the bondconverts. This can happen for several reasons. Firstly, there may be tax,accountancy or regulatory advantages in issuing through an offshorefinancial subsidiary with a guarantee from the parent company. This can beto the issuer’s advantage, for example, the old UK convertible capital bondstructure allowed issuers to treat coupons as interest while accounting for theinstruments as equity, effectively creating very tax efficient equity.Alternatively, it can benefit the investor (possibly passed back to the issuerthrough keener pricing). For example, bonds may be issued offshore to avoidwithholding tax. (Indeed, many ‘true’ exchangeables are also issued fromoffshore financial subsidiaries to avoid withholding tax or capital gains, or,indeed, simply because this is where the underlying shares are held).

Secondly, some companies issue through subsidiaries to take advantage ofbetter tax and accounting treatment in the subsidiary’s tax jurisdiction. Forexample, Roche 0% 2021 USD was issued out of the company’s on-shore USsubsidiary (Roche Holdings Inc) to take advantage of the tax efficient CoPay

FAS 137 and IAS 39 may

force companies to

account for optionality

through P&L

There may be risks in

mistaking subsidiary

exchangeables for

convertibles, especially

if there is no guarantee



structure (discussed in detail later). There can be restrictions on this and,specifically, companies are normally restricted from using too much leveragewithin foreign subsidiaries, as this would allow earnings to be repatriatedwithout taxation (these rules are generally known as ‘Thin Capitalisation’regulations.

Some companies issue bonds out of their principal operating subsidiaries asthese have better credit ratings, though conversion rights will still be into theparent. This structure is not overly common and tends to occur where theoperating subsidiaries are utilities or utility-style businesses with highlyregulated cash flows (often former state businesses that have beenprivatised). This can create problems for investors in that while the operatingsubsidiary is the better credit, in nearly all cases, this will represent the bulkof the group’s assets and cashflows and, therefore, any default is likely tostem from this entity. The problem for investors occurs when the subsidiarygoes into default, where there is no guarantee from the parent company. Inthis situation, it is entirely possible for the parent company to have separateassets over which bond investors have no rights. Consequently, the parentcompany shares may retain some value, even if bondholders do not get paidout in full.



OCEANE-style bonds

OCEANEs (Obligations à option de Conversion et/ou d’Échange en ActionsNouvelles ou Existantes) are a French innovation, allowing issuers to sellbonds that either convert into new shares or are exchanged for existingshares, at the issuer’s choice. This style of bond has no tax or accountingbenefits and, indeed, for these purposes is treated as a convertible. The realadvantage of the structure for the issuer is the extra balance-sheet flexibility itprovides, as it allows the issuer to deliver either Treasury shares or newshares on conversion.

OCEANEs give the issuer great flexibility with their balance sheet. The abilityto deliver existing shares creates a great route for the disposal of Treasuryshares, while if these are needed for other corporate purposes, conversioncan be met through the issue of new capital. Finally, the use of a cash-outoption means that the Treasury shares can be cancelled if the company isover-capitalised at the time of conversion. The flexibility afforded byOCEANEs allows French issuing companies to actively manage their balancesheets, making this a very popular (and common) structure in France.

From the investor’s perspective, the key impact is on dividend entitlement. InFrance, new shares may have different dividend entitlements to old sharesand so investors may be affected by whether new or old shares are delivered.Old shares are entitled to dividends with respect to the XD date. New sharesare entitled to dividends for the financial year of conversion and beyond.

This is best explained using an example: ABC SA has a financial year endingon 31 December and pays an annual dividend that goes XD on 1 April. If aholder of an OCEANE converts after 1 April in any year, there will be nodifference between old and new shares and both will rank for the followingyear’s dividend. If a holder converts before 1 April, then old and new shareswould be treated differently. Old shares would rank for the next dividend,while new shares would receive their first dividend the following year.

Figure 2: Different implications of the outcomes of converting an OCEANE bond

Bondholder‘Converts’

bond

Issuer hasbalancesheet

flexibility,

can decideto either:

A:Deliver

existing shares

B: Deliver new

shares

Dividend: Entitlement begins

from financial year ofconversion and beyond

Dividend treatment: entitled

to dividend from the ex-date

Source: Deutsche Bank

Issuer has option to

deliver new OR existing

shares upon conversion,

giving issuer balance-

sheet flexibility

Key difference between

new or old shares is the

investor’s entitlement

to dividends



Despite the complexity with regard to dividend entitlement, investors are noworse off than if the company had sold a vanilla convertible (a French vanillaconvertible issue would give the worst-case dividend entitlement of anOCEANE). OCEANEs are now a very well established investment vehicle and,indeed, have almost become the standard within the French domestic market,though the structure does not appear outside France.



Cross-currency bonds

Cross currency convertibles are those in which the bond is denominated in adifferent currency from that of the underlying stock. This means thatinvestors have currency exposure on the option portion of the convertible,because this will be affected by the exchange rate.

Parity = (stock price x conversion ratio) / FX in local currency

This formula means that if the currency of the underlying stock weakens,parity will fall, even if the stock price remains unchanged. However, theremay well be some offsetting correlation between the stock price and theexchange rate. This can be for operational business reasons (for example,where the majority of the company’s profits are earned in the currency of thebond rather than the currency of the shares) or for valuation reasons (forexample, in an industry where companies tend to be valued againstinternational peers).

Consequently, when modelling cross-currency convertibles, investors need toadjust the volatility of the underlying share by its correlation with exchangerate movements. Alternatively, investors can calculate the stock’s volatility inthe currency of the bond and this will take any correlation into account. Thisvalue is then used in the binomial model as the volatility assumption for thecross-currency convertible. Using volatility in the currency of the bond stripsaway most of the complexity of valuing cross-currency convertibles.

However, when pricing cross-currency new issues, investors shouldremember to use the OTC volatility of the underlying in the currency of thebond. When there is no OTC options market in the underlying, investorsshould use the long-dated historic volatility of the underlying as a guide, butagain in the currency of the bond. Failing to use the volatility in the rightcurrency can seriously affect the accuracy of the new issue valuation.

Accurately modelling

cross-currency bonds

requires correlation

analysis between

underlying share and

exchange rate



Pre-IPO convertibles

The last few years have seen several companies issue bonds that give someform of optionality in the event that an IPO or a corporate listing occurs.Clearly this ‘optionality’ is completely dependent upon whether the issuerproceeds with the IPO and, consequently, the value that the market ascribesis somewhat limited and these issues tend to be very bond orientated. Theprincipal reason why companies sell these issues is to signal to the marketthat an IPO is planned and highly likely, increasing interest and coverage(while at the same time raising at least as much as could be achieved througha straight bond issue).

In this research, we have looked at three different pre-IPO structures, whichgive very different investment profiles and which have very different potentialimpacts on the IPOs themselves. Firstly, we have considered the COREstructure, which, in essence, is a straight bond that becomes a convertible ifthe IPO occurs. Secondly, we have considered the Vivendi (Environment)1.5% 2005 Euro, which contained an option to convert into VivendiEnvironment shares at the IPO. Finally, we have looked at the KDIC pre-IPOconvertible, which has a similar structure to the CORE bonds, but with adifferent reference price for the conversion ratio.

CORE bonds – Convertible On Reference Event

Figure 3: Structure of a CORE

CORE

Bond

Trigger event

does not occur

Trigger event

occurs

Bond redeemed at an

enhanced level

Investors ‘put’ bond at

issue price

Investors receive pre-

defined convertible


CORE bonds conditionally become convertible, dependent upon whether ornot a specified event occurs. Usually, but not exclusively, this event is an IPO,though it could potentially be a share sale or completion of an acquisition orsimilar event. If the triggering event does not occur within a specifiedtimeframe, the bond is simply redeemed at favourable terms for the investor,giving a bonus yield above the issuer’s straight debt. However, if the eventdoes occur, the bond will become convertible on pre-defined terms. Investorsalso have the option to put the bond back to the issuer at the issue price,

Several different

structures give some

form of optionality over

an IPO

CORE structure returns

an enhanced straight

debt return in the

worst-case scenario



should they decide they do not want the convertible at the time of thetriggering event, protecting them against changing market conditions.

The bond can be thought of as a conditional forward on a pre-definedconvertible bond. In fact, allowing for the put, the bond is a conditionalEuropean-style option on a forward on a pre-defined convertible bond. Whilethe issue in itself can be taken as an indication of the intent of the issuer,there is still a degree of uncertainty regarding the triggering event. Thisuncertainty is offset by a higher expected return to investors whether thereference event occurs or not, as the investors either holds a bond with anenhanced yield (which is therefore worth more than the issue price) or aconvertible which has even greater value.

How to value the CORE structure

Working out a true theoretical value is problematic, as it is impossible toquantify the chance of the triggering event occurring and therefore it is notpossible to assign objective probabilities as to whether investors receive theconvertible or the redemption proceeds. Working out the minimum value ofthe issue is far easier – this is simply the lower of the two possible outcomes(ie, the forward on the convertible or the cashflows received if the triggeringevent does not occur). As the clear intention/expectation of the issuer is thatthe triggering event will occur, investors are far more likely to receive the(higher valued) convertible than the straight bond.

Valuing the forward convertible presents some difficulties. Convertiblevaluations tend to be versed in terms of implied volatility rather thantheoretical value, but this forward structure has cashflows attached up untilthe triggering event and there may also be an element of premiumredemption attached to the yield if the triggering event does not occur.Investors should use the redemption price if the reference event does notoccur as the issue price of the convertible if they wish to calculate its‘forward’ implied volatility.

In terms of the other assumptions, investors should use the relevant forwardportion of the yield curve and the forecast for dividends based after the lastpossible date for the reference event. Investors are effectively getting theenhanced yield and then, if the reference event occurs, are receiving aconvertible at this implied.

Alternatively, investors can use conservative assumptions to calculate atheoretical value for the convertible at the potential IPO date and then use thistheoretical value as the ‘redemption price’, together with any couponsreceived, to work out the potential yield of the core bond from issue to theIPO date.

How is the premium calculated?

If the IPO price is used as the reference price for the premium, hedging ofconvertible positions could then put the IPO under pressure, either beforelaunch in the ‘grey’ market or immediately after the IPO. To alleviate thisproblem, the reference price for the CORE bonds is based on an averagemarket price after the triggering event. The actual price used to calculate thisaverage will depend upon where the underlying is listed, but could be theclosing auction or the opening price or VWAP. The number of days in theaveraging period will depend on the liquidity of the underlying. Using this

Investor uncertainty

offset by higher

expected return

Difficulty in estimating

probability of QPO

creates problems in

calculating theoretical

value

Investors can use the

theoretical value to

calculate the CORE

bond’s yield to IPO



averaging period to calculate the reference price for the convertible shouldminimise the impact on the IPO and will help to maintain an orderly after-market.

Vivendi Environment

An earlier example of a pre-IPO was the bond sold by Vivendi Environment(at the time a wholly owned subsidiary of Vivendi), which was guaranteed byVivendi and converted into shares of Vivendi (either new or existing).Investors also had the opportunity to convert into shares of VivendiEnvironment if and at the time an IPO occurred, effectively at a discount tothe IPO price. This is a significantly different structure to the CORE bonds, asinvestors end up with shares at the IPO, rather than a convertible.

Indeed, the Vivendi Environment IPO did occur and a substantial proportionof bondholders did convert into the new company. The mechanics of thisconversion was that the market price of the convertible bond was increasedby 5% and this was then converted into Vivendi Environment at the IPO price.Because of the relative size of the IPO and the market capitalisation of theconvertible at the time, bondholders’ participation was limited toapproximately 50% of their bonds. The rump of the bonds still trade andremain convertible into Vivendi.

One of the key advantages of the Vivendi Environment structure from aninvestor’s perspective is that investors get exposure to the new companyfrom the IPO price. In other words, investors are buying ‘conditional’ delta,whereas with a CORE bond, investors are buying ‘conditional’ volatility (thereference price is struck as an average over a trading period after the IPO).

However, this advantage for the investor is a serious disadvantage for thecompany, in that a Vivendi Environment-style structure allows arbitrageaccounts to attack the IPO price by holding a long-bond position and short-selling the IPO shares ahead of this to capture the discount offered throughthe convertible. Indeed, the Vivendi Environment IPO took place underdifficult market conditions and the pre-IPO shorting caused by this convertiblestructure contributed to the IPO price range being lowered twice and nearlycaused the whole offering to be postponed.

KDIC

The Korean issuer KDIC sold a pre-IPO convertible in 2001 that wassomething of a cross between the Vivendi Environment and the COREstructure. Like the CORE bonds, there is no conversion unless an IPO occursand after a qualifying IPO, the bond becomes a convertible. However, unlikeCORE-style bonds, the reference price is the IPO, giving investors immediateexposure to the shares following the IPO, but also potentially leading to shortselling ahead of the share offering.

A significantly different

structure, as investors

end up with shares at

the IPO

Pricing mechanism had

a strong detrimental

impact on the IPO



Chooser convertibles

Chooser convertibles are a relatively recent and rarely used innovation, but inessence are simply bonds with a `best of’ option into a number of differentunderlying equities. The first of these issues - the Swiss Re triple - gaveinvestors the right to convert into shares of Swiss Re itself, or into shares ofeither Credit Swiss or Novartis at the investor’s choice. This structureobviously gives greater value to investors than a vanilla Swiss Re convertible(with all other terms being equal) or, indeed, an exchangeable into either ofthe two other stocks. Indeed, some outright accounts have viewed this bondas an excellent play on the Swiss market, on the grounds that at least one ofthe underlying stocks would outperform the index.

Figure 4: Swiss Re Triple – Parity is the ‘best of’ the three component parts of the exchange property

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

90%

Feb-00 Apr-00 Jun-00 Aug-00 Oct-00 Dec-00 Feb-01 Apr-01 Jun-01 Aug-01 Oct-01 Dec-01

Swiss Re CS Shares Novartis Parity

Credit Suisse shares form

parity

Novartis shares form

paritySwiss Re

shares form parity

Whilst diversification of ’best-of’ option reduces downside exposure, it also reduces

the volatility of the option value

Source: Bloomberg, Deutsche Bank,

However, because at the time the bond is sold it is impossible for investors toknow which particular underlying share (if any) will provide the optimalconversion, this instrument is not popular with ‘stock-picking’ outrightinvestors and these investors never seem to fully appreciate the value of theadditional optionality.

Indeed, part of this relates to problems with modelling chooser convertibles.Chooser options themselves are well-understood exotic options, but areusually European exercise and therefore modelled as such. Chooserconvertibles need to be modelled as American options and have far greaterpath dependency and, unfortunately, few convertible models have this typeof chooser functionality built in. Consequently, few investors are able toaccurately evaluate these bonds, which affects the market price even forthose that can. As only a small number of chooser bonds have been issued,many investors have not developed the required additional functionalitywithin their models, but simply allow a small amount of additional impliedvolatility to allow for the enhanced optionality.

Structure gives greater

value than a vanilla

convertible

Greater path

dependency in the

calculation of American-

style chooser options

makes them difficult to

model when embedded

within a convertible

bond



From the company’s perspective, the advantages of selling a chooser optionsimply boil down to opportunity and pricing. For an issuer with relativelylarge stakes in a number of different companies, which is happy to sell part ofany of these stakes, issuing a chooser effectively has minimal cost, as theissuer is indifferent as to which stock the investor converts into. However,even though many participants in the market do not fully evaluate theenhanced optionality, investors do recognise that there is additional valueand this allows tighter terms and, therefore, cheaper financing, even thoughthey probably do not fully account for the value of the chooser option.

Chooser convertibles have the same accounting treatment as exchangeablesand under US GAAP, the bond will be bifurcated (ie, split into bond andoption components), with the option component then ‘marked to market’through the issuer’s P&L. However, depending on the correlation of theunderlying shares, a chooser option may have lower volatility than a singlestock option, reducing the volatility of the bond’s P&L impact.

A refinement on the chooser convertible is the addition of the ‘parity switch’,which gives the issuer greater flexibility in which underlying is delivered. Thisfeature allows the issuer to deliver the underlying of its choice but with amarket value equal to the value of the shares the investor wishes to convertinto, with an additional premium paid to the investor for the inconvenience ofnot getting the stock of their choice. The mechanism for determining themarket value of the two stocks involves an averaging period, so that investorscan fully hedge their position. (Telecom Italia OPERA notes are a goodexample of this).

Lower option volatility

will reduce the volatility

of the P&L impact



Conversion features - micro

1. CoCo

2. Cash-out options

3. Resets

4. Make-whole

5. Takeover protection



CoCo bonds

Contingent Conversion (CoCo) features are an accounting innovationdeveloped to minimise the dilutive impact of convertibles under US GAAP,introduced in the US in late 2000. Basically, conversion is only possible undercertain specified circumstances, most commonly related to the share price.While these are not satisfied, the company need not account for the dilutionassociated with conversion. CoCo issuers have tended to be high creditquality companies focused on limiting dilution. Maturity has tended to belong (most commonly 20 years), but these issues have had relatively lowinitial deltas (particularly for US issues), with high bond floors maintained byrolling puts (CoCo features have commonly appeared in bonds that alsocontain CoPay and Lyon features).

Figure 5: Convertibility of CoCo bonds for movements in parity

70

80

90

100

110

120

130

140

150

May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02

Par

ity

20 trading day average shareprice falls below 115% ofconversion price - bonds

NOT convertible

20 trading day averageback above 115% - bondsbecome convertible again

20 trading dayaverage share

price above 115%trigger - bondsare convertible

Source: Reuters, Deutsche Bank

The restriction on conversion with these bonds is related to the share priceand is generally expressed in terms of parity. A fairly standard examplewould be to only allow conversion if the share price exceeded 110% of theconversion price, though this can be complicated if the bond is also aLYON/OID (where the conversion price will rise at the accretion rate). Also,some CoCo bonds have a sliding conversion hurdle, generally starting at120% of the conversion price, falling to 110% over the life of the bond.

Restrictive conditions

upon conversion rights

allow CoCo issuers to

avoid immediate

dilutive impact of

convertible issuance



Figure 6: Trigger levels of US CoCo deals in 2001

0

5

10

15

20

25

110% 120% 125% 135%

Trigger

No

. of

dea

ls

Source: Reuters, Bloomberg, Deutsche Bank

Clearly, investors need to be protected against calls or corporate actions thatcould be used to take away all of the optionality in the bond (ie, if the bondwere called while conversion was restricted, investors would be unable toconvert, even if parity were above 100% of the conversion price).Consequently, the contingent restriction on conversion is lifted in certaincircumstances. Specifically, the bonds will become convertible under mostM&A scenarios, or if any qualifying capital distributions are made, andconversion is also allowable if the bonds are called for early redemption.

These standard protection features give significant comfort to investors andremove some of the foreseeable additional event risks of the CoCo structure,but often the trigger levels for special dividends, for example, remain highand therefore a significant risk. Investors should also be wary of the need toconvert a bond in order to participate in an unforeseen (and thereforeuncovered) corporate action.

Even assuming the event risks are fully covered, this structure still hasvaluation implications for investors. The graph below gives the payout atmaturity of a bond with a 110% CoCo feature. The lost optionality betweenparity of 100% and 110% could be repurchased within the OTC market,potentially allowing easier valuations, though liquidity may make thisimpractical and expensive, especially as CoCo bonds tend to be very long.

Lost optionality can

theoretically be

replicated in the OTC

market, but this may

not be practical



Figure 7: Pay-off profile of CoCo bonds versus standard convertible

EquityIssue price

Lost optionality

due to CoCo

structure

Share price Conversionprice

CoCo Trigger

To

tal r

etu

rn

StandardConvertible

High gamma

around CoCo

trigger level


A long call option with a strike equal to parity of 100% and short call withstrike equal to parity of 110% neatly replaces the lost optionality of the deadzone. However, as a hedge to normalise the convertible, even this isimperfect, as it still leave investors with an additional return (10 points) ifparity finishes above 110%. The best way to correctly and fully model CoCobonds is to build the feature into convertible tree-based (eg, binomial) or grid-based (eg finite difference) models in a similar manner to soft calls. However,many investors have yet to update their models to allow for CoCo features,and as a general rule of thumb, the market assumes CoCos are worth one ortwo implied volatility points off the value of the convertible.

There is an additional concern with CoCos, though this problem is unlikely toemerge in the near term with existing issues due to the long maturities ofcurrent CoCo bonds. Hedging CoCos approaching maturity would beexceptionally difficult if parity were in the dead zone, as the delta of the bondwould fluctuate wildly, depending on whether the bond’s conversion featureswhere activated or not. This problem may be exacerbated by the exactmechanism of the stock trigger (whether it was a rolling 20 consecutive days,20 out of 30 trading days, etc) and while this high gamma is not negative, itcertainly creates significant risks for arbitrage investors.

This is not as much of a problem at the put dates, as it is hard to visualise arealistic scenario under which investors would put the bonds were parity in

Bonds near CoCo

trigger will have

substantial gamma as

maturity approaches



the dead zone (without a corporate action), as the option value should begreater than the put price. Indeed, this problem is unlikely to occur at all withexisting issues due to the high number of puts and calls before maturity, butfuture deals may have shorter maturities, or fewer early redemption features(particularly if the structure is adapted for European issues).

The greatest risk to investors and, in particular, arbitrage investors withregard to CoCo bonds concerns their treatment by prime brokers. Unless thecontingency features have been triggered, the bonds are non-convertible andtherefore an arbitrageur’s long-bond position does not match their short-stock position, in that they cannot necessarily convert to meet their short-stock position. Currently, prime brokers are not accounting for this mismatchrisk with CoCo bonds when calculating margin requirements from andleverage available to convertible arbitrage investors. However, this mismatchdoes exist and any change in attitude from prime brokers would be likely tohave a significant impact on ‘the basis’ of CoCo bonds.

CoCo bonds certainly take value away from investors, but the accountingbenefits to issuers mean that without changes to accounting principles, thisfeature is likely to remain commonplace. Indeed, while we do not believe theaccounting treatment under US GAAP is universal, preliminary inquiriessuggest other accounting regimes give similar treatment and investors ininternational convertibles (and in particular in Europe) should becomefamiliar with this structure.

One final and often ignored consideration is that issuers may have greatlyincreased volatility of stated diluted EPS if the share price fluctuates aroundthe CoCo trigger. As we have seen with chooser convertibles, this issomething that issuers often seek to avoid, though so far, this has notdiminished CoCo issuance.

Valuation of CoCo

bonds at risk from

potential changes in

Prime Brokerage

accounting

CoCos may lead to

increased EPS volatility



Cash-out options

Cash-out options are now almost universally included in exchangeable bondsand are becoming far more common, even in convertibles. This feature givesissuers the ability to deliver the cash value of the underlying securities onconversion and thereby greatly enhances the flexibility from the issuer’sperspective. With an exchangeable, this means that the issuer need notphysically hold the shares for delivery, but can hedge out their exposure withderivative transactions or, indeed, if the shareholding has increased inimportance, the issuer need not deliver shares that they wish to retain. Fromthe perspective of a convertible issuer, a cash-out option will give thecompany much of the additional balance-sheet flexibility of an OCEANE,preventing equity from being issued if the company is overcapitalised.

From the investor’s perspective, the existence of a cash-out option does notin itself affect the valuation. What does make a difference is how the cashvalue of the underlying securities is calculated and specifically whether thereis a ‘look-back’ option for the issuer. The cash value of the underlyingsecurities will be determined over an averaging period. If the issuer knowsthe value from this averaging period (ie, if they can ‘look back’) before theydecide whether to give the investor cash or shares, they have the opportunityto deliver whichever has the lowest value. This optionality for the issuerclearly takes value away from the investor.

Extracts from US Cellular 0% 2015 USD bond prospectus:

In lieu of the delivery of Common Shares upon notice of conversion of any

LYON, the company may elect to pay the Holder surrendering a LYON an

amount in cash equal to the Sale Price of a Common Share on the Trading

Day immediately prior to the Conversion Date multiplied by the Conversion

Rate…

…the Company shall inform the Holder through the Conversion Agent, no

later than two business days following the Conversion Date, (I) of its election

of the delivery of Common Shares or to pay cash in lieu of delivery of such

shares…

If the Company elects the delivery of Common Shares, such shares will be

delivered through the Conversion Agent as soon as practicable following the

conversion date. If the Company elects to pay cash, such cash payment will

be made to the Holder surrendering such LYON no later than the fifth

business day following such Conversion Date.

…The “Sale Price” on any Trading Day means the closing sale price per share

for the Common Shares…

Source: US Cellular 0% 2015 USD Bond Prospectus

Look-back options are very common in US issues and, indeed, investorsshould expect US issuers to extract the maximum value from these clauses.In Europe, cash-out options are seen as creating flexibility for issuers ratherthan necessarily creating value and even where the issuer has a look-backoption, many will tell investors of their intentions in advance. Indeed, laterissues in Europe have removed the look-back from cash-out options,

An increasingly

prevalent clause that

gives the issuer the

option to deliver the

cash value of shares

upon conversion

Primary concerns are

the timing mechanics of

the decision and the

method of calculating

the cash value of

conversion



requiring issuers to inform trustees (and therefore investors) of theirintentions regarding the cash-out option in advance.It is also possible that an issue can actually give a look-back option to theinvestor. This happens when the issuer is obliged to inform the investor inadvance of whether they intend to give cash or shares and where theaveraging period is prior to the conversion date. This can effectively give alook-back ‘put’ option to investors if the company chooses to deliver cash.

Figure 8: Characteristics of cash-out option and look-back option on US Cellular 0% 2015 USD

Conversion date

The date on which the bondholder

gives notice of their intention to

convert bonds

Cash reference date

Closing share price used to

reference cash amount

Decision date

Date at which company

has to inform investors of

election to pay cash in

lieu of shares

Cash payment date

The date on which the bondholder

receives the cash payment if the

company have made the election to

do soDuration of

investors’ short

call position

Source: Bond prospectus, Deutsche Bank estimates

Rare examples exist

where the investor has

the benefit of a look-

back option



Resets

One of the most interesting developments in the convertible market in themid-1990s was the introduction of ‘reset' clauses. Reset clauses (often calledparity resets) mean that on certain dates, the conversion price is reset to alevel at (or near) the prevailing share price (ie, if the shares fall, you get moreof them per bond to make up for the fact that they are worth less). In theory,resets can be upwards or downwards, but so far, all bonds containing resetshave allowed downward-only adjustments to the conversion price – ie, allcurrent resets can only create value for investors. There is always a maximumlimit on the adjustment, which means that the conversion price can beadjusted down to a certain minimum, often 80% of the initial conversion priceat issue.

This feature is most frequently found in Japanese and Asian (especiallyTaiwanese) convertibles. In Japan, resets are often attached to mandatoryissues, which have unique characteristics and are discussed more fully in thesection on mandatory securities. The Taiwanese issues have often come fromtechnology-based growth companies, which have been keen to see theirconvertibles swapped into equity and have particularly wished to avoid cashoutflows from redemption. By attaching resets to their convertible bonds,these companies have increased the probability of conversion, while stillallowing issues to have healthy initial premiums. This has proved particularlypopular in Taiwan, where resets have been used to partially offset thedisadvantages investors face through lack of stock borrow and the longconversion process.

Figure 9: Parity reset convertible bond payoff

Equity

Issue price

Parity reset

level

Share priceLower stockprice reset

level

Initial conversionprice

To

tal r

etu

rn


On certain dates, the

conversion price may be

adjusted (invariably

only downwards) to a

maximum limit

Reset features

historically most

prevalent in the

Japanese and

Taiwanese markets



In the last couple of years, resets have started to appear in a few Europeandeals, sold by smaller issuers. The payoff graph demonstrates that the resetprovides support for lower credit quality issuers, or issuers where the creditcorrelates strongly with the share price, effectively replacing the bond floor.Indeed, the diagram above, showing payoff for a parity-reset convertible,demonstrates that for a high credit quality issuer, this feature will essentiallycreate an additional second ‘bond’ floor. This feature has only appeared in asmall number of European deals, but nevertheless, we believe it may increasein frequency amongst smaller issuers.

Obviously, reset bonds greatly increase the path dependency of the bond’soptionality and consequently increase the difficulties in modelling thesebonds. Early evaluations used Monte Carlo simulations (see ConvertibleSecurities: An Investor’s Guide, page 73 for an example of how this is done),but in reality, the feature needs to be built into a tree-based or (preferably) afinite difference model to calculate accurate values and Greeks. Once again,the difficulties in modelling the feature means that its value to investors isgenerally underestimated, creating opportunities for investors who fully getto grips with the feature.

Figure 10: Gamma characteristics of reset bonds

0%

20%

40%

60%

80%

100%

120%

140%

1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201

Parity

Del

ta

Normal Reset Mandatory reset

Reset bonds typically display an inversecorrelation between stock price and parity

around the reset level - this is negativegamma which is bad news for

arbitrageurs as rehedging involves buyingshares high and selling them low


One of the problems for arbitrage accounts trading reset bonds is that‘negative gamma’ situations can arise. This is because if the shares aretrading in the reset zone, it will seem probable that the conversion ratio willrise on the reset date and, consequently, the theoretical delta may increase asthe share price falls. In this situation, an arbitrageur wishing to remain deltaneutral will be forced to sell as the share price falls and then buy them back if

Accurate valuation and

derivation of Greeks

best achieved via finite

difference model

Negative gamma can

catch out convertible

arbitrage investors



the shares were to recover. Consequently, volatility in this reset zone ofnegative gamma can cause the arbitrage investor to make substantial losses.

This problem is far lower with a reset bond than a reset mandatory (see thesection on mandatory securities), as the bond floor itself will act like a putoption on the shares, giving some positive gamma in the reset zone andpartially offsetting the effect of the reset. Indeed, positive gamma will pick upstrongly if the share price falls below the reset zone. However, this is onlytrue where the credit is strong and where there is minimal credit correlationwith the stock price. When the issuer is a weaker credit, the delta profile willbe closer to that of a mandatory reset.



Make-whole

Make-whole features are a relatively common and well-understood feature ofthe US market and were particularly prevalent in the technology boom of1999 and early 2000. Elsewhere, these features are very rare and poorlyunderstood. Make-wholes have generally been used as a supplement to earlyprovisional calls, effectively protecting the investor’s income advantage overthe shares and increasing the suitability of the issue for equity and income-based investors.

The issuer benefits because if the shares perform, the company will be ableto force conversion earlier, thereby strengthening the balance sheet. Clearly,this feature is best suited to second-line credits among growth stocks and thisexplains why it featured so frequently among US high-tech issuance.

Make-wholes fall into two categories - premium make-wholes and couponmake-wholes. Premium make-wholes are designed to appeal to thoseinvestors that look at breakeven (the time it takes for a convertible’s couponsto pay back the premium), while allowing the issuer to force conversion if theshare price performs. With premium make-wholes, the investor recovers theoriginal premium paid at issue, less the value of any coupons received if theprovisional call is activated. There is some variance between issues and theexact conditions will be spelled out in the individual documentation.

Coupon make-wholes work in a slightly different way. Here, the investorreceives the unpaid coupons from the provisional call period, ie, the investoris guaranteed to receive all interest up to the first hard call date, even if aprovisional call is exercised prior to this date. Again, there are somevariations in how the make-whole is applied and investors need to check thedocumentation. In particular, some make-wholes pay the full value of anyremaining coupons, while others only pay the discounted NPV of theremaining coupons.

The early redemption of the bond remains optional, as the company maydecide that forcing conversion is not economic, particularly with a premiummake-whole, where the make-whole payment could be significantly greaterthan the coupons remaining before provisional call protection expires. Also,no company wants a potentially large cash liability arising at a time out oftheir control, as could happen if the provisional ‘calls’ became mandatory!

For the sake of clarity, it is worth pointing out that investors receive the make-whole payment if they convert following a soft call, but not if their bonds areredeemed. This effectively reduces the likelihood of the company beingforced to redeem following a call, even if the shares plunge, as parity wouldhave to fall below the redemption value by more than the make-wholepayment before it would be economic to redeem rather than convert.

Traditionally, make-wholes have been used with high soft-call triggers andthere has been minimal risk that a company would be required to redeem thebond after exercising the soft call. However, as we have discussed, the make-whole payment only applies after conversion. Indeed, if the make-wholepayment were only given to holders who converted immediately followingthe call notice, the risk of the issuer being forced to redeem the bonds wouldfall even further. This may allow even highly volatile companies to useprovisional calls without running the risk of being forced to redeem thebonds, possibly even with lower trigger levels.

The predominantly US

feature protects

outright investors from

early calls

Make-wholes are either

premium or coupon

based

Payment only effective

upon conversion and

not upon redemption



The relative value of premium versus the coupon make-wholes to theinvestor is dependent upon the level of the initial premium and the size of thecoupons. Obviously, with low premium and high-coupon bonds, couponmake-wholes will be more valuable, and vice versa. As better credit qualitycompanies will be able to achieve issues with higher premiums and lowercoupons, the relative merits of these two structures are somewhat dependantupon the actual credit of the issuer.

In terms of valuing make-wholes, the feature is included in many convertiblemodels. However, as issuers who include this feature tend to be belowinvestment grade, there is likely to be strong credit correlation with the shareprice, which can complicate the valuation. We have ignored this creditcorrelation to demonstrate the valuation impact of make wholes.

Figure 11: Premium protection from make-whole provisions

105

110

115

120

125

130

135

140

100 105 110 115 120 125

Parity

Th

eore

tica

l val

ue

No call & no Make Whole Callable & no Make Whole

Callable & premium MakeWh l

Callable & coupon MakeWh l

Coupon and premium makewhole provisions mitgate thevaluation impact of callability


Merits of the two

structures dependent

upon the credit quality

of the issuer



Takeover protection

Takeovers remain the biggest area of ‘event risk’ concern within theconvertible market. When the conversion/exchange property (ie, theunderlying equity) is acquired or merged with another entity, the overridingconcern for convertible holders will be what the conversion rights change toand whether they will retain any optionality. In most takeovers, the targetcompany continues to legally exist as a (subsidiary) stock corporation of theacquirer and in many jurisdictions, there will be no automatic right ofongoing conversion into the dominant company. In this case, unless there arespecific structures protecting the investors, or unless the acquirer voluntarilymakes a more generous offer, bondholders are forced to either convert orretain the bond without any conversion rights. (In truth, the bond would stillbe convertible into the unquoted and wholly owned subsidiary andconsequently, the conversion rights are valueless).

Figure 12: What happens in a takeover?

Of limited

concern, value

of bonds

adjust to

volatility of

new

underlying

shares

Is there a

reinvestment

clause?

Lost optionality due

to zero volatility of

cash component

YES

NOYES

Value of optionality

dependent upon

reinvestment

property

Convert Retain bonds

without

optionality

NO

Both clauses only apply for

a specified time period,

usually 60 days

Enhanced

conversion

window - 2

main types

Average

premium

enhancement

Stepped

conversion (or

ratchet) clause

NOYES

YES

Are there specific structures

protecting bondholders?

Has the acquirer

made a more

generous offer?

NO

Issuer receives offer proceeds in lieu of

their shareholding which traditionally

becomes new exchange property

NO

Does the deal include

cash?

Is the bond an exchangeable?

Takeover event


A series of structures have been developed to protect investors underchange-of-control scenarios, though in some countries, there is also someelement of statutory protection; for example, in France, it is usual for anacquirer to allow continued conversion into the acquired shares. Change ofcontrol structures fall into two categories, protection for convertibles andprotection for exchangeables. Protection for convertibles generally takes theform of an increase in the conversion ratio, applicable for a short period afterthe takeover offer goes unconditional – generally referred to as an enhancedconversion window.

Largest area of ‘event

risk’ in convertible

market - each situation

must be rigorously

analysed on a case-by-

case basis



There are two main conventions for enhanced conversion windows. The firstis stepped conversion (or ratchet) clauses. Here, the enhanced conversionratio that is applicable is determined according to a schedule set out in thebond’s prospectus. This will generally fall as time goes by from the issue dateto the first hard call. On the announcement of a change of control, convertibleholders will have a window of usually 60 days to convert at the prevailingenhanced ratio. The second type of protection for convertibles is averagepremium enhancement. Here, the clause states that under a change ofcontrol, the conversion ratio is enhanced according to the average premiumof the bond over a given time period (normally the 12-month period endingthe month before the last complete calendar month). Again, the enhancedconversion window only applies for a specified time period, normally 60 days.

With exchangeables, the situation is somewhat different. The issuer may notown any additional shares of the underlying and so may not be able to givean enhanced conversion window. Even if they did, they certainly would notwant to commit to delivering these extra shares in a takeover, as this wouldrestrict their flexibility. However, the issuer will receive the proceeds of thetakeover offer in lieu of their shareholding underlying the convertible andtraditionally this has become the new exchange property. Where the offer isentirely for shares, there is no problem, but in the event of a cash takeover, alloptionality may be lost (cash has no volatility) and where there is a partialcash element, optionality will be ‘diluted’. Also, when cash does remain in theexchange property, the key factor is whether or not this is reinvested for thebenefit of the investor or whether the issuer receives the interest.

In recent exchangeables, protection has been included to prevent cashdilution of optionality in the event of takeovers. This has taken two forms:continued optionality and cash compensation. Continued optionality is themore common form and the structure developed for the Munich Re/Allianzexchangeable is the most comprehensive. Here, the issuer has agreed toreinvest any cash proceeds from a takeover in other equity securities in theexchange property or in shares of the acquirer, or if neither of these isapplicable, in an equity index (the DAX in this case). This essentiallyguarantees the investor optionality over the life of the bond.

The alternative form of protection gives compensation for any cash elementin an accepted offer - Allianz/Siemens 2% Euro 2005 is a good example. Hereagain, there is continued conversion in an all-share offer, giving continuedoptionality. However, where cash is included, investors are compensatedaccording to a complex formula, in part dependent on how much cash ispresent in the offer.

Protection for

convertibles involves

either stepped

conversion terms or an

average premium

enhancement

Protection for

exchangeables centres

on what becomes the

conversion property –

watch out for the

treatment of cash



Mandatory structures

1. Introduction

2. PERCS

3. DECS

4. Feline prides

5. Mandatory resets




Introduction

Lower dividend yields in the 1990s created problems for the vast array of USequity income mutual funds, especially as many of the more exciting (at leastat the time) equity investments were in high-growth technology stocks, whichdid not pay dividends. This led to the creation of a whole new class ofmandatory convertible instruments, which give equity investors greaterincome in exchange for reduced upside participation. These ‘convertibles’mandatorily convert into ordinary shares at maturity and so there is nodanger of the issuer having to find cash to redeem them. Consequently, thereis only limited optionality for the investor and the exposure profile is verydifferent from a traditional convertible.

The key difference between a mandatory and a traditional convertible is thatthe investor does not have the option to receive cash on redemption (ie, theoption to not convert has gone) and so shares will always be issued. From theissuer’s perspective, this means that the convertible should count as equity interms of rating/balance sheet. Often, the conversion ratio will changedepending on the price of the shares at maturity. This means that if the shareprice rises, often the conversion ratio will fall, reducing the amount of equitythe company has to issue and increasing the attraction from the issuer’s pointof view, as if the shares rise, investors are effectively buying equity at apremium. For the outright convertible investor, mandatory convertiblesprovide exposure that is almost equivalent to equity, while for the arbitrageinvestor, the embedded options in mandatories are very different from atraditional convertible.

There is a plethora of different acronyms associated with US mandatoryconvertibles, as each of the issuing investment banks have come up withtheir own name, but in essence, there are two basic structures (PERCS andDECS), with variations on these structures sometimes altering theircharacteristics. In addition, we have considered the different exposure that isgiven through Japanese mandatory reset preference shares. Finally, so-called‘feline prides’ have become more popular recently.


developed out of

increased demand for

yield from US equity

income investors

Shares always issued

upon redemption,

therefore bonds count

as equity on balance

sheet

Two basic structures

known as PERCS &

DECS



PERCS

Preferred Equity Redeemable Cumulative Stocks (PERCS) are preferredshares that automatically convert into one ordinary stock upon maturity,(which is usually four years). PERCS are usually issued at the prevailing shareprice, convertible into one ordinary share, with an enhanced dividend yield.Other names for PERCS include TARGETS, CHIPS, EYES, PERQS and YEELDS,though this is a far from an exhaustive list. From the issuer’s perspective,these mandatory securities generally count as equity, though as PERCS paydividends, the income is distributed ‘post-tax’ and is a non-deductibleexpense.

The ‘redemption’ in the acronym refers to the fact that these preferenceshares have a finite life and the only cash that the investor receives is thedividend payments. PERCS pay a higher dividend than common shares, butthe equity upside is capped. Above a certain share price, the conversion ratiowill fall as the stock rises, capping the upside at that level. Below this level,the conversion ratio remains one for one, giving the same downsideexposure as the ordinary shares, excluding the income difference.

Figure 13: Components of a long position in a PERC

Long stock Short call

European style

struck at ‘Cap’

Income swap

PERC for Ord

dividends

Analysis involves comparing PV of dividend

income against theoretical call price


In terms of valuation, the PERCS structure is very simple. In buying a PERC atissue, an investor is essentially buying the shares (less any dividends over thelife of the instrument) and selling a call option struck at the price of the cap.However, rather than receiving the premium for this short-call option as anup-front capital payment, the investor will receive an income stream from thecompany as a series of dividend payments. Investors modelling PERCS needonly calculate the value of the call they are short and compare that againstthe present value of the PERCS income advantage over the ordinarydividends.

Usually issued at the

prevailing stock price,

convert 1:1 and pay

holders a quarterly

dividend

Investors accept capped

upside for enhanced

yield

Long stock and short

call, fair value of the call

should equate to NPV

of the income

advantage over the

ordinary shares



Figure 14: PERC convertible payoff

Equity

Issue price

PERCS yield

pick-up

Share price Cap level

To

tal r

etu

rn


Generally, the investor does not have American exercise and cannot convertPERCS ahead of maturity. However, most PERCS are callable at any time bythe issuer, with a call price that declines over time, generally to the level ofthe share-price cap. Investors also receive the value of unpaid and accruedinterest. Normally, shares are delivered on PERCS that are called, butoccasionally issuers have the right (but obviously not the obligation!) todeliver cash. The general equation for the conversion ratio for PERCS thathave been called early is:

Number of shares = (call price + accrued and unpaid dividends)

Market price of the shares

The complicating factor is that the market price of the shares tends to bedetermined by an averaging period, which ends before the issuer decides tocall the bond, effectively giving them a look-back option. This obviouslycreates risk for the investor, though this is limited, because if the closing priceon the day after the five-day averaging period is significantly below (ie, 95%or less of the five-day average), then this lower closing price will be used.Nevertheless, the look-back option clearly gives value to the issuer, thoughthe issuer will always be ‘paying’ all unpaid dividends up until maturity andthe lowest call price is generally at the cap level. Therefore, there is littleincentive for the issuer to call the bonds early, even with the look-back.

Callable PERCS (most

are) have a call price

that declines over time

Watch out for averaging

periods and look-back

clauses



One of the difficulties in trading PERCS is that because the instrument isbasically stock with a short-call position, there is negative gamma. This canbe particularly severe approaching maturity if the share price is close to thelevel of the cap. (Shorting an ATM call close to maturity is clearly not a greatposition to be in!) Figure 15 shows the falling delta as the share price risesthrough the cap. Finally, investors should consider that there will besignificant dilution after PERCS mature. The product is structured to suitequity income accounts and the shares that arise on conversion may well notyield enough for his class of investor. Therefore, unlike traditional convertiblebonds, it is likely that many outright accounts will hold PERCS through theconversion process, selling the underlying equity as they receive it. This canresult in technical pressure on the share price, which in turn could create anexcellent technical opportunity for equity investors. Outright PERCS holdersshould probably sell ahead of this.

Figure 15: At issue delta of three-year PERC with Euro 130 cap

0%

25%

50%

75%

100%

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200 210 220 230 240 250

Stock (Euro)

Del

ta


The PERCS structure is very flexible and can easily be modified to alter theinvestor’s exposure. For example, Microsoft issued 2.75% convertibleexchangeable principal-protected preferred shares, which, in addition to theusual long-stock, short-call structure, also contain a long (stock-settled) putstruck 21.125% out of the money. As always, with a PERCS-type structure, theoptionality is expressed in changes to the conversion ratio, though in thiscase, the issuer has the opportunity to deliver cash.

Another variation is to restrict rather than cap the investor. This is done byeffectively reducing the number of short calls within the structure, therebygiving the investor upside above the ‘cap’ level – albeit at a reduced rate.Thus, if the structure were effectively short 75% calls, the investor wouldretain 25% upside above the level of the cap. Obviously, as the investor haseffectively sold fewer calls, the enhancement to the income will be lower.

PERCS are not immune to the CoPay revolution, though this requires somesignificant modifications to the basic structure. As preferred shares, PERCSpay dividends and are therefore excluded from contingent interest payment

As PERC involves long

stock and short call, the

instrument must have

negative gamma



rules. However, it is possible to achieve CoPay treatment by restructuringcapped equity products as junior subordinated mandatory convertible debtproducts. (See the section on CoPays to see why issuers may choose to dothis and what the implications are for both issuer and investor).



DECS

Dividend Enhanced Convertible Stocks (or alternatively Debt Exchangeablefor Common Shares) is the second main type of mandatory structure. Theseinstruments are generally either preference shares or subordinated bonds,which, like PERCS, mandatorily convert into ordinary shares at maturity (ifunconverted before this). If the DECS are structured as debt, then the incomewill be classed as interest and will be deductible, but preference-sharestructures pay post-tax dividends. Other names commonly used for DECSinclude PRIDES and ACES.

DECS give no significant downside protection and these instruments are veryequity sensitive, with minimal direct bond characteristics and interest-rateexposure. Again, as with PERCS, some of the upside performance is givenaway and in return, the investor receives an enhanced yield over the ordinaryshares. However, unlike PERCS, the investor’s upside is not capped with theDECS structure, but rather the ‘price’ that the investor pays for the enhancedincome is a zone of flat exposure.

DECS, like most mandatory structures, are far more common in the US thanelsewhere, but despite the relative lack of equity income investors in Europe,we have still seen a couple of reasonably large DECS issues (NationalGrid/Energis and Daimler Chrysler). Nevertheless, Europe has yet to reallyembrace mandatory structures and neither of these two issues has reallydriven investor interest. Still, DECS remain a very well understood instrumentwithin the US.

Figure 16: Component parts of a long DECS position

Short European call

optionThree year struck at-the-

money

Long 0.8 European call

option

Three year struck 25% out-of-the-money

Long stock Income swap

DECS for Ord dividends

Analysis involves comparing PV of income

swap against difference in option premiums

Short at-the-money option has greater value

than smaller long out-of-the-money position


DECS can be structured

as either debt or equity

depending on the needs

of the issuer

Retain downside

exposure, but give up

some upside exposure

for an enhanced yield

Predominantly a US

phenomenon



DECS are generally issued at the same price as the underlying shares, but theconversion ratio depends upon the prevailing stock price at maturity. If theshare price is at the issue price or below, the conversion ratio will be 1:1,giving the investor all the downside of the shares, though with a significantlyenhanced yield (and therefore a far higher total return). Between the issueprice and a set higher level (generally a premium of 20%-25%), theconversion price will rise with the share price, such that the investor hasneither capital gain nor loss. Above this level, the investor will regain upsideexposure at the lowest conversion ratio.

Figure 17: DECS convertible payoff

Equity

Issue price

DECS yield

pick-up

Share priceTrigger 1 (Usuallycurrent share price)Conversion ratio = 1

Trigger 2 Conversionratio <1

To

tal r

etu

rn


With DECS, investors can convert at any time, but only at the lower minimumconversion ratio. Given the enhanced yield, coupled with the possibility ofgetting a higher conversion ratio, there is almost no scenario in which itwould be economic to voluntarily convert early (it would require phenomenaldividend growth), though an uncompensated corporate action (specifically atakeover or special dividend) could force early conversion.

As with PERCS, there is often an early redemption feature, with calls commonin the final year of the typical four-year structure. The call is generally at asmall premium to the issue price plus accrued interest, but is payable in stock(the number of shares that the investor receives will not fall below theminimum). As the issuer will save interest (or dividends as the case may be) ifthe DECS is retired early, calls are likely to be exercised as long as the shareprice is high enough to ensure the maximum conversion price. However, ifthe shares have not performed, the call will unlikely be used, as this wouldlead to higher dilution.

There is a ‘dead zone’

between issue price and

an upper limit where

the conversion ratio

adjusts down as the

share price rises

Despite American-style

optionality, there are

very few scenarios in

which it would be

economic to exercise

early



A DECS is like a convertible in that all the embedded optionality is contingentand when a holder converts, he simply owns shares with no residual optionposition. This is significant with DECS (as opposed to PERCS), as the investorhas American exercise and the issuer may have a call option. Consequently, atrue DECS model will be tree based and operate in a similar manner to aconvertible model.

However, it is exceptionally unlikely that a DECS will be voluntarily convertedearly by the investor and as the structure is mandatory, the effect of anissuer’s call is more limited than with a convertible. Consequently, manyinvestors split DECS into their basic four components and indeed this willgive a very accurate approximation of the value of the instrument. Looking ata three-year non-callable DECS with an initial 25% premium, the fourcomponents are:

1. Long one share

2. Short one European three-year call struck at-the-money

3. Long 0.8 European three-year call struck 25% out-of-the-money

4. Income swap of ordinary dividends for DECS payments (ie, NPV ofincome advantage).

(Alternatively, the long one share, short one ATM call option can be thoughtof as a short one European put at the issue price plus a zero coupon bondpaying the issue price at maturity. In this case, the NPV of the incomeadvantage is simply replaced by the NPV of the DECS payments. This way oflooking at DECS will give the same result, but makes it harder toconceptualise and compare DECS against the underlying ordinary shares).

By breaking out the optionality in this way, it becomes necessary to use avolatility surface when valuing the different options, as the strikes varysignificantly and so investors need to allow for volatility skew. This valuationmethodology also explains where the additional income of the DECS over theordinary shares comes from. The short at-the-money option position clearlyhas greater value than the smaller long out-of-the-money position and thisdifference should represent the NPV of the income swap.

Like a convertible, all

embedded optionality is

contingent

Volatility surfaces

required to value the

different embedded

options



Figure 18: At issue delta of a DECS

0%

20%

40%

60%

80%

100%

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 180 190 200 210 220 230 240 250

Stock (Euro)

Del

ta

Delta on short call struck at Euro 100 Delta on long 0.8 call struck at Euro 125 DECS delta

Period of negative gamma as short option position picks up delta

faster than long 0.8 option position with

the higher strike

Strike of 0.8 long call position

Strike of short call position


The major problem with this approach is that it makes no allowance for anycallability within the DECS structure. As the two embedded options arecontingent and given that the issuer will only realistically call the bond if theshares are well above the higher strike of the long call position, the impact ofthe call feature on the value of the DECS’ optionality is small. However,ending the instrument early will result in a decrease in the instrument’sincome advantage and will therefore affect its valuation, though subject togiven the path dependency.

For a callable DECS structure and without running the valuation through truetree-based or finite-difference models, the investor has to make a subjectiveestimate of how long the extra income will last and therefore what the impactof the call will be on the valuation.



Feline prides

Feline prides represent a further enhancement to the DECS structure, inessence giving greater flexibility by allowing the investor to break the productup into its constituent parts. This lets the issuer use the structure to tapseveral different types of investor simultaneously. The best way to explainthis is to look again at the constituents of a DECS.

1.Short one at-the-money put

2.Zero-coupon bond redeeming at issue price

3.DECS coupon payments

4. Long 0.8 three-year call struck 25% out-of-the-money (illustrative numbers).

This way of looking at a DECS does not allow the easiest comparison againstthe shares, but does allow the product to be packaged into two components.Firstly, the ‘zero coupon bond’, which gives redemption equal to the issueprice, must be the issuer’s credit as they hold the cash. When this is puttogether with the DECS dividend payments, investors effectively have apreference share. (This could be a subordinated bond if the DECS werestructured as junior debt rather than preference capital).

The second element of the DECS is the ‘purchase contract’, represented bythe two options. The short put and long call position give the economicexposure of the mandatory conversion, but in reality, this is a simplification,as ‘conversion’ still takes place, even if the shares are between the twodifferent strikes at maturity. In essence, investors still receive (and have topay for) shares, even if both the short put and the long call options end upout of the money. There are no valuation implications, as investors willreceive stock equal to the issue price. In reality, the investor has entered intoa forward share-purchase contract with a varying conversion ratio, such thatthe economic exposure is equivalent to a short put/long call position.

Feline prides let the

investor break the

product into its

constituent parts

The shares are always

issued and ‘optionality’

is really a share-

purchase agreement

with short put/long call

economics



Figure 19: Feline prides share-purchase contract

Despite long call short

put economics,

investors ALWAYS

receive shares

Share price

Co

nve

rsio

n r

atio


So by repackaging the constituents, we can view a DECS slightly differently,with constituents of a:

1. Preference share

2. Share-purchase agreement

This is exactly what the feline prides structure does and the basic DECS unitis here referred to as an ‘income pride’. However, the investor can then breakthe unit up and trade (ie, sell) the preference share if desired, eliminating thecredit exposure. This creates a problem for the issuer, in that while the share-purchase contract is mandatory, if the preference share is sold, the companyhas no guarantee that the investor will pay the cash specified under thepurchase agreement.

Consequently, in order to break up the income pride, the investor needs tocollateralise the purchase agreement by placing zero-coupon Treasuries intrust to meet the purchase cost. The resultant instrument is effectively acollateralised share-purchase agreement and is generally referred to as a‘growth pride’. The growth pride does not pay income, but there may be anominal structuring fee paid quarterly to the investor.

Income pride = Preference share + share-purchase agreementGrowth pride = Zero-coupon Treasury + share-purchase agreement

Investors can swap (and indeed re-swap) between the two different types offeline pride by substituting in the required security, allowing investors to stripout the preference share (or Treasury share should they so choose). Also atissue, the company can sell a mixture of preference shares, income prides



and growth prides, thereby tapping a wider investor base. Finally, theseinstruments tend to be issued out of a trust (see deductible equity and, inparticular, the section on TOPrS) and consequently often have tax calls,though as they are mandatory securities, the valuation implication is limited.

Figure 20: Repackaging feline prides

Treasury

Incomepride

+

Preferenceshare

Growthpride

+

Treasury

Incomepride

=

Preferenceshare

Growthpride

=

+

+




Mandatory resets

Reset clauses can be attached to mandatory structures, operating in a similarmanner as with reset bonds. The reset clauses work so that on one or morespecified dates, the conversion price is reset to a level at (or near) theprevailing share price (ie - if the shares fall, you get more to make up for thefact that they are worth less). There is always a maximum limit on theadjustment, which means that the conversion price can be adjusted down toa certain minimum, often 80% of the initial conversion price at issue. Thereset feature will give investors some downside protection, preventing capitallosses up to the level of the reset floor, acting a little like a bond floor.

Below the reset floor, the instrument will once again pick up exposure to anyfurther falls in the underlying stock and so investors might not be protectedagainst particularly sharp falls in the shares. Because reset features giveinvestors a measure of downside protection, mandatory structures with thisfeature have greater value (and therefore will be issued with lower coupons).In theory, resets can be attached to any mandatory structure, including DECSand PERCS, but they have most commonly appeared in the Japaneseconvertible market, where they have normally been attached to mandatorysecurities without any other optionality.

As we have previously said, resets greatly increase the path dependency ofthe optionality and consequently increase the difficulties in modelling theseinstruments. The difficulties in modelling the feature means that its value toinvestors is generally underestimated, though it should always beremembered that a downwards reset can only increase value for the investor.

Figure 21: Delta of a mandatory preference share with a reset clause

0%

20%

40%

60%

80%

100%

120%

140%

1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 161 171 181 191 201

Parity

Del

ta

Normal Convertible Mandatory reset

Mandatory reset bonds typically display asevere inverse correlation between stock

price and delta around the reset level - thisis negative gamma which is bad news forarbitrageurs as rehedging involves buying

shares high and selling them low


Many of the

characteristics of a reset

bond

Resets provide a

measure of downside

protection



As with reset bonds, mandatory resets exhibit negative gamma and, indeed,as there is no offsetting bond floor, the situation is far worse. This is becauseif the shares are trading in the reset zone, it will seem probable that theconversion ratio will rise on the reset date and consequently the theoreticaldelta will increase as the share price falls. In this situation, an arbitrageurwishing to remain delta neutral would be forced to sell as the share price fallsand then buy them back were the shares to recover. Consequently, volatilityin this reset zone of negative gamma can cause significant losses forarbitrage investors. For the sake of clarity, it is worth remembering that resetsadd value for the investor and that this negative gamma is simply increasingthe difficulties of arbitrage trading and secondary market making of theseinstruments under certain conditions.

It is very difficult to unbundle the optionality embedded within resetstructures, especially where there are multiple resets or where the reset isahead of maturity. However, where there is a non-callable structure with areset at maturity, the convertible can be split into its component options togive an accurate valuation and this gives a good theoretical insight into howthe feature works. The best way of showing this is through example.

ABC Corp non-callable mandatory reset preferred

Conversion premium 25%Parity reset at maturityReset floor 80% of reference price at issue

The valuation of each preferred approximates to the following options (allEuropean exercise with the same maturity as the preferred):

1. NPV of the reset level (usually nominal value)

2. Short 1.25 puts (ie, nominal value/reset floor) struck at the reset floor

3. Long 0.8 calls (ie, nominal value/conversion price) struck at theconversion price

4. Income swap of ordinary for preferred dividends (i.e. NPV of incomeadvantage)

Alternatively this can be expressed as:

1. Long one share at the reference price

2. Short one call at the reference price

3. Long 0.8 calls at the conversion price

4. Long one put at the reference price

5. Short 1.25 puts at the reset floor

6. Income swap of ordinary for preferred dividends

The lack of a bond floor

increases the negative

gamma phenomenon



Clearly, this alternative is a more complex (and therefore less likely)methodology to use, but it does demonstrate how the option bundle is usedto create income. Stripping out the stock, the four option positions havenegative net value. The ‘payment’ for this option position is the enhancedincome and the income swap should equal the option for the mandatory resetpreferred share to be fairly priced. Some investors use either of the abovetwo methodologies to calculate the value of Japanese mandatories withmultiple reset dates, valuing the options to the next reset date only. Clearly,this has limitations, but it can provide a useful approximation of thestructure’s true value.

Despite being complex,

stripping out the stock

and four option

positions can still be

useful



Zero-coupon bonds and accreting

structures

1. Accreting structures

2. OIDs

3. Premium redemption bonds

4. Double-zero structures



Accreting structures

In terms of valuation, the prevalence of arbitrage (implied volatility) basedmodels means that the investor can compare across different structures and,in theory, should therefore be indifferent as to how a bond is structured forbonds with an equal value (ie, equal implied volatility). Nevertheless, someinvestors have a particular sensitivity to income (ie, coupons), especially fundmanagers whose own fund pays an annual dividend/coupon to theirunderlying investors. Also, for arbitrage investors, the current yield can be acritical component in the financing of the overall position.

Conversely, from the issuer’s perspective, the coupon is a pre-tax charge anda high coupon can therefore have an impact on the company’s statedearnings per share. Consequently, a low running cost (ie, a low coupon) isoften the key variable of the convertible that the issuer wants to minimise. Inthis case, the wishes of the investor and the issuer are diametrically opposed.Nevertheless, as the convertible market tends to be driven by the investor’sdemand for new issues, issues tend to end up with coupons closer to therequirements of the issuer than the investor!

Obviously, lowering the coupon reduces the bond floor, which, in turn,reduces the valuation. This can be mitigated in two ways, which may even beused together; firstly, by giving the investor puts on the bond and secondly,by redeeming the bonds at a higher price than that at which they are sold.Where the bonds redeem at a higher level than the issue price, the fixed-income value of the convertible will accrete over the life of the instrument.The combination of this accretion rate, together with any coupons, will makeup the instrument’s yield to maturity. Accreting structure can take severaldifferent forms, but in essence, the valuation impact is similar.

Negative effect of low

coupon on bond floor

can be offset by puts

and/or a redemption

value above issue price



OID bonds (Original Issue Discount) bonds

Zero-coupon bonds by definition pay no coupons and give investors noincome. Yield to maturity is achieved by means of an issue price below finalredemption value (ie, investors pay 60 today for a bond maturing in five yearsat 100 - giving a YTM of around 10.5%). Zero-coupon convertibles werepopularised in the US in the mid-eighties by Merrill Lynch, which introducedthe acronym LYONs (Liquid Yield Option Notes).

The traditional Lyons structure has a maturity of 15–20 years, but the bondwill contain rolling puts, often every five years, and generally is callable bythe issuer from the fifth year onwards. Consequently, it is highly probablethat either the put or the call will be exercised in the fifth year, as underpractically all circumstances, it would be optimal for either the issuer or theinvestor to exercise their option. Therefore, investors can consider the firstput and call date to be maturity. (Given the put, the bond cannot be worthless than this).

Figure 22: Zero-coupon convertible – defensive security

Equity

Issue price

Share price Conversionprice at issue

Effectiveconversion price at

maturity

To

tal r

etu

rn


Roche 0% 2010 USD is a good example of this structure. The bond was issuedat 35.628 on 20 April 1995 and redeems at par (100) in 2010, giving a YTM of7% from issue. The next put is in 2003, when the bond also becomes callable,and so we expect this issue to disappear next year. Calls and puts arecalculated according to ’accreted value’. Accreted value is the price that keepsthe yield to maturity constant. Roche 0% 2010 USD is callable on 20 April2003 at 61.778, which represents a 7% yield from issue.

When an investor converts a zero-coupon bond, the accreted interest is lost.Consequently, the effective conversion price will accrete over the life of thebond and the maturity payoff diagram shows that the return on the bond will

Yield provided via an

issue price below the

final redemption value;

widely used in the US

market

LYONS are usually long-

dated bonds with

rolling puts and usually

callable from fifth

anniversary onwards

Roche 10s & 12s

provide good examples

of the structure

Accreted interest lost

on conversion



remain constant unless the share price rises very significantly by maturity.The difference between the conversion price based on the issue price and theconversion price based on the final redemption price is the disadvantage(from an investor’s point of view) inherent in zeros, though investors shouldremember that this is taken into account in arbitrage valuations.

There are clear positives to the issuer in using a zero-coupon structure;principally, there will obviously be no cash running cost of the bond and theeffective conversion price of the bond will increase as the bond accretestowards par. Also, the accretion rate is tax deductible in all majorjurisdictions, giving the issue a tax shield for interest that has not been paid,while the EPS dilution will be minimal or small.

Of course this is not a one-way street and Lyons have a higher yield thanequivalent current coupon bonds, assuming conversion does not take place,and indeed the probability of conversion is reduced due to the escalatingpremium. If conversion does not occur, the company will have to pay out theprincipal and all the accreted interest in one single transaction, possiblycreating liquidity and refinancing problems for the issuer.

Zero-coupon OID bonds received a huge new lease of life in the US in 2000 asa result of the contingency revolution; both CoCo and CoPay bonds havebeen discussed at length in other sections.

Issuer benefits from no

cash running costs and

an accreting conversion

price…

…but provide investors

with a higher yield than

equivalent current

coupon bonds



Premium redemption bonds

In Europe, bonds are also frequently issued below their redemption price, butoften still retain a small coupon, generally for two reasons. Firstly, manyEuropean investors are loath to buy convertibles with lower income than theunderlying shares and so there is significant pressure from investors for newissues to have a coupon at least as large as the dividend yield. This is not tosay that deals do not occur with coupons below the dividend yield, but ratherthat this is far less frequent than in the US.

Also, in some European countries, there is some uncertainty as to how zero-coupon convertibles will be treated for corporate tax purposes. In Germany,some issuers are concerned that tax authorities will break up zero-couponconvertibles into the component equity options and treat these bondsdifferently for tax purposes. Consequently, some issuers will have anominally low coupon, even if this is not strictly needed.

Figure 23: Zero-coupon convertible is comprised entirely of equity derivatives

Long stock Accreting

equity putDividends


This leads neatly into the other major difference between the US andEuropean convertibles markets with regard to accreting structures. In the US,the OID structure is the most common accreting structure, while in Europe(including the UK, but less so in Switzerland), premium redemption is thestandard for accreting convertibles. Here, bonds are not issued at a discountto their nominal value, but rather redeem at a premium. From both theissuer’s and the investor’s perspective, the economics of premiumredemption versus original issue discount are identical and, indeed, justrepresent a scaling up or down on the basis of the individual bonds.

Premium redemption

structures often provide

YTM with a low coupon

OIDs standard in the

US, while premium

redemption structures

more prevalent in the

European market



Table 1: Premium redemption versus OID stucture

Premium redemption Original issue discountIssue price 100% 50%Issue size $100m $200mProceeds $100m $100m

Coupon 2% 1%Cost per coupon $2m $2m

Redemption price 200% 100%Redemption proceeds $200m $200m

Conv. price per nominal $10 per share $20 per shareConv. price at maturity $20 per share $20 per shareTotal number of shares 10 million shares 10 million sharesSource: Deutsche Bank estimates

As the table above demonstrates, there is no difference to either the issuer orthe investor between the two structures in terms of interest payments andeffective conversion price of the bond. However, the premium redemptionstructure does allow easier comparison against current coupon bonds foraccreting structures that also contain coupons and this in part explains whyEurope continues to follow the premium redemption structure, while the OIDconvention is more popular in the US.

However, the reason why the different structures were developed in the firstplace is that in certain European jurisdictions, OID structures have historicallybeen treated differently for tax or accounting purposes and, indeed, in somelocations, it was simply not possible to issue bonds at a discount to nominalvalue. These historical differences have now lapsed and there is no differencein treatment between the two structures, but nevertheless, the two differentconventions remain.

Indeed, the OID structure is simply not possible for issuers who wish to usethe French conventions, as here, bonds are issued at their nominal value(trading dirty and converting on a one-for-one basis). Consequently, Frenchissuers who want to use accreting structures have to issue premiumredemption bonds if they wish to follow French market conventions. Ofcourse, there is nothing from a legal, tax or accounting perspective to stop aFrench issuer from adopting the standard Euro-market conventions, but theFrench conventions remain as popular as ever with French issuers.

Equity dilution and

interest cost unaffected

by choice of OID or

premium redemption

structure

Historically, certain tax

and accounting

practices responsible

for limiting use of OID

structure in Europe



Double-zero structures

A more recent innovation has been the issue of convertibles without eitherincome or yield, ie, bonds that have no coupons and also zero accretion rates.Consequently, the conversion price remains fixed throughout the life of thebond and, indeed, as there is no yield, the conversion price will be lower thanwith other structures. The bond floor that generates option value for investorsand therefore premium for the issuers is created by a series of short-datedputs. Indeed, this structure seems to be ideal for issuers, as clearly, it will beEPS accretive and at redemption/conversion there will be no implicit interest.However, what is great for issuers in this case does not necessarily suitinvestors and this will obviously be reflected in the pricing attained.

Figure 24: Double-zero convertible

Long stockRolling Puts

European style

struck at the

conversion price

Dividends


The structure is in essence simply stock minus dividends plus a string ofEuropean stock puts struck at the conversion price. Clearly, this limits thetype of investors who will be interested in the structure at issue, bond fundsget no yield and equity funds get no income. Indeed, even for dedicatedconvertible funds, lack of yield is often a disadvantage, and this structuretherefore has a much more limited investor base even than zero-couponaccreting structures. Finally the short dated puts needed to keep the bondfloor high increase the likelihood that the issuer will be faced with a largeand, indeed, uncontrolled cash outflow, possibly creating liquidity andrefinancing problems.

Issuance of double-zero bonds has been limited to just a couple of issues inEurope, but in Asia and, in particular, Taiwan, many issuers like the structure,as these companies tend to issue very low premium bonds and often have astrong desire to preserve interest expense.

Zero-coupon, zero-yield

issues usually have low

premiums and a

number of short-dated

puts

Lack of yield the

primary concern for

many investors



Convertibles and the balance sheet

1. Convertibles and the balance sheet

2. Subordinated bonds

3. Structural subordination

4. Preference shares

5. Deductible equity

6. Convertible capital bonds

7. Soft mandatory redemption



Convertibles and the balance sheet

One of the key criteria with an issuing company is where a convertible will sitwithin its balance sheet and therefore what the implications will be for creditratings of other public debt. Indeed, depending on how a deal is structured, aconvertible may even class as equity. Naturally, many issuers want tominimise the impact of convertible issuance on their existing debt (even ifthis bears a higher cost). Obviously, longer maturity bonds have a lowerimpact, especially perpetual bonds, and indeed, some convertibles havedeferrable interest specifically to be considered closer to equity.

However, the most common way in which issues are made closer to equity isby altering the ranking of the convertible. This has increased the popularity oftwo structures: subordinated convertible bonds and convertible preferenceshares. In the European convertible market, subordinated bonds are far morecommon than convertible preference shares. This is because preferenceshares pay their ‘interest’ post-tax and this effectively raises the cost of theinstrument unless the investor can claim a tax credit (which needs to beincluded in the at-issue pricing in order to make the instrument competitivefrom the issuer's perspective). Indeed, in the UK, there was an activedomestic convertible preference share market until Advanced CorporationTax and the associated dividend tax credit were abolished. After this, the UKdomestic convertibles market has all but ended, though a few rump issuesremain outstanding.

Figure 25: Subordinated bonds and preference shares may receive equity credit

Debentures /Secured

Senior /Unsecured

SubordinatedUnsecured

Preferenceshares

Ordinaryshares

Possible equity

treatment

Debttreatment

Equitytreatment


A primary concern of

issuers is where any

capital raised will sit on

their balance sheet

Both subordinated

convertibles and

convertible preference

shares move an issue

closer to equity



Subordinated bonds

Subordinated bonds count as debt for tax purposes and rank ahead of allequity (including preference shares) in a winding up of the issuer. However,subordinated bonds will not receive any payments until all obligations tosenior bondholders have been met and this is the reason why the impact ofsubordinated issues on senior bond ratings is mitigated. From theperspective of the investor, the impact of subordination can be difficult toassess.

The amount of senior debt at the time of issuance is a clear indicator as tohow much wider subordinated debt should trade, but investors should beaware that subordinated debt rarely, if ever, contains negative pledges orrestrictive covenants. Therefore, senior debt can and is likely to be increasedif the issuer gets into financial difficulties and this may reduce the issuer’sability to meet its obligations to holders of subordinated debt. The quality ofsubordinated debt may well be diminished even further if the issuer pledgesassets as security when refinancing senior bonds.

Finally, subordination can have a severe impact on the investor base. Thiscan be from two perspectives. Firstly, some investors cannot take (or havelower limits on) subordinated debt. Secondly, subordinated debt will have alower credit rating (which, in itself, is likely to affect the investor’s limits), buteven more significantly, if the rating falls below investment grade, this willimpact the potential investor base greatly. Finally, the market forsubordinated debt within credit derivatives is at best highly limited and sothis reference point is often missing for investors, increasing the risk.

Subordination is likely to remain a feature of the European market andinvestors need to know how to value these issues. Very high credit qualitycompanies (eg, AXA) may be able to maintain solid stable investment graderatings on subordinated issues, even with a liquid credit derivatives market(both asset swap and CDSs have been available for subordinated AXA paper).Under such circumstances, the credit derivative spread allows easy valuationof the convertible.

However, with many other issues, this is not the case and, indeed, in theNetherlands, in particular, there are many unrated subordinated bonds. As arule of thumb, investors should assume that subordinated paper is at leastone notch lower than senior unsecured debt, though in fact, subordinationmay have a greater impact upon the rating of the bond than this. Finally,subordinated debt is likely to see a far more severe negative reaction thansenior debt if the issuer gets into (or is perceived to be getting into) financialdifficulties. Some investors use deep out-of-the-money equity puts to helphedge subordinated debt.

Despite counting as

debt, subordinated

bonds usually have

limited impact on senior

bonds

Rarely contain negative

pledges or restrictive

covenants

Investor base restricted

by limits on

subordinated debt

and/or investment-

grade ranking



Figure 26: Yield on subordinated CB versus senior straight bond

4

6

8

10

12

14

16

18

20

Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01

Yie

ld %

KPN 6.25% 2005 EUR StraightKPN 3.5% 2005 EUR CB

Source: Bloomberg, Deutsche Bank



Structural subordination

Investors should be aware that the title of the bond does not necessarilyindicate where a bond will rank against other debt within the issuer’s groupof companies. Normally, most debt will be issued or guaranteed out of thehead holding company, and what will be important to the investor is howtheir bond ranks with other debt within the holding company. Occasionally,senior bonds from a financial subsidiary or SPV will only have a subordinatedguarantee from the group holding company (KBC 2.5% 2005 Euro is a goodexample of this). Clearly, here, investors should consider the debt assubordinated debt of the parent.

However, far more serious and often far less apparent is when the debt of thesenior company has fewer rights than the debt of its operating subsidiaries.This is similar to the situation of subsidiary exchangeables, except that ratherthan issuing out of the higher-rated subsidiary, the bond is sold from thelower ranked parent. In essence, the parent’s only assets are itsshareholdings (often 100%) in its operating subsidiaries. If these subsidiariesthemselves have gearing, in a winding up, all debt at the subsidiary level(including subordinated debt and even potentially redeemable preferenceshares of the subsidiary) would have to be repaid before the parent receivesany cash.

Consequently, any debt at the parent level (even senior) is effectivelysubordinated by the group’s structure. A good example is provided by thetwo Telewest convertibles, which are both senior, but with structuralsubordination, and indeed here, this is very well explained within the issues’documentation.

Figure 27: Structural subordination

Parent

company

Subsidiary

A

Subsidiary

C

Subsidiary

B

Senior

bonds

Bank

loans

Senior

bonds

Bank

loans

Senior

bonds

Bank

loans

Senior

bonds

Bank

loans

All redeemableinvestors at the

subsidiary level getpaid out before parent

receives a penny

In this example, debt heldat the parent company isthe last to get paid out!


Senior debt at the

subsidiary level may be

guaranteed only on a

subordinated basis

With structural

subordination,

subsidiary debt

(including prefs) has

greater rights than

senior parent debt



Preference shares

The abolition of the dividend tax credit effectively ended the UK preferenceshare market and the high cost to the issuer of post-tax preference-sharedividends versus interest payments means that convertible preference shareshave not really caught on within other parts of the European market. Indeed,in Holland, for example, the subordinated debt market has been used in placeof preference shares and some Dutch lenders will give balance-sheet credit todomestic subordinated issues similar to that for preference shares.

However, in the US, the high number of equity income mutual funds (whichare also instrumental in the development of the US mandatory market) haslead to a significant number of issuers of convertible preference shares.These preference shares often offer a significant yield enhancement over theordinary shares, though obviously for a premium.

US preference shares often have a nominal value of $50 and there are anumber of other differences between these convertible preference shares andstandard convertibles bonds. As with all preference shares, missing apreference dividend is not an act of default, but the issuer is prevented frompaying ordinary dividends while preference dividends are in default – this is acritical difference between preference shares and subordinated bonds.

Indeed, some of these issues are true equity and are irredeemable (ie, thesepreferred are equity, in that the issuer is not obliged to ever give the investortheir money back or indeed to ever pay any dividends). The marketconvention for irredeemable preference shares is to treat them as 50-yearredeemable structures. While this is clearly inaccurate, the NPV ofredemption 50 years out is so small that this inaccuracy is not material,especially as the credit spread and therefore discount rate on these bondstends to be high.

The conventions for US preference shares differ from those for convertiblebonds. Almost always, these issues have an official listing on the NYSE andtherefore have documentation that meets the appropriate requirements. Thepreference dividends tend to mirror ordinary dividends and therefore areusually paid quarterly. Also, as preference payments do not count as trueinterest, accrued is not broken out within the price and preference shares willtrade ‘dirty’.

Preference shares will rank junior to all debt. However, whereas outside theUS all preference shares tend to rank equally, US issuers will often issuedifferent series of preference shares with different rankings (ie, seniorpreference shares, junior preference shares, etc). While issues within thesame series will rank equally, this still creates an extra layer of complexitywhen analysing the balance sheet and appropriate credit spreads.

One of the more recent innovations allows preference shares to be re-marketed at maturity. This provision allows the issuer to extend the maturityby changing the coupon to an appropriate level, potentially procuring newbuyers for the instrument. This provides the issuer with an alternative tosimple cash redemption, potentially reducing refinancing problems andmaking the instrument more equity-like.

Demand from equity

income funds has led to

significant issuance in

the US

Missing a preference

dividend is not

necessarily an act of

default…

… and the principal

never needs to be

repaid with an

irredeemable preference

share

Re-marketable

preference shares allow

issuers to extend

maturities



‘Deductible equity’

From the issuer’s perspective, the ideal structure would be an issue thatcounts as equity on the balance sheet, but which the tax authoritiesconsidered to be an interest payment, allowing payments to be made pre-taxand thereby effectively reducing the cost to the issuer by the corporation taxrate. This represents something of a holy grail for issuers, a structure that intheory strengthens the balance sheet, but which is partially paid for by the taxauthorities.

A number of different structures have been developed globally, which givethis treatment, though in reality, all are very similar. Often, the exact nature ofthe structure will have to vary depending upon the specific tax andaccounting regime of the issuer. In essence, all these structures involveissuance from a special purpose vehicle that will give equity on consolidation,but payments are made via inter-company loans and are generally taxdeductible.

TOPrS, QuIPS and MIPS

In the US, several structures were developed in the mid-1990s that give theissuer a measure of equity treatment, but with dividend payments that are taxdeductible. Of these, the TOPrS (Trust Originated Preferred Securities) orQuIPS (Quarterly Income Preferred Securities) are probably the most generic,though in reality, they are all based on pretty much the same structure andgive the issuer very similar benefits.

The instruments themselves are essentially convertible preference shares,usually paying quarterly dividends and quite often with long maturities (toincrease the equity credit), which in some cases may even be extendable.Conversion is usually American and there is normally a call after five years(though call protection in some cases is shorter). From the investor’sperspective, the instrument is exactly the same as a convertible preferenceshare, with the same characteristics, and should be valued as such.

The benefit to the issuer lies in the structure behind the TOPrS rather than inthe instrument itself. The issuing company sets up a Delaware StatutoryBusiness Trust as an SPV to actually sell the preference shares to theinvestors. The Trust buys convertible subordinated debentures from theparent company and sells TOPrS with exactly the same terms to the public(indeed, these preferred securities may even be secured against thesubordinated convertible debentures). The key factor is that the parent ownsall of the ordinary shares in the Trust and this allows full consolidation.

Deductible equity is

something of a ‘holy

grail’ for issuers



Figure 28: Structure of a TOPrS

IssuerTrust

(SPV)

Nominal amounts, maturity

and cash flows identical on

both sides of transaction

•Subordinateddebenture +

interestpayments

•Preferred shares+ quarterlydividend Public

Cash Cash


As the trust is fully consolidated, the liability of the debentures from theparent’s perspective is matched and cancelled out by the debentures as anasset of the Trust and so the debentures do not appear on the parent’sbalance sheet. This simply leaves the preferred securities of the Trust as newequity (on a consolidated basis) for the parent. As the parent does actuallymake interest payments on the debentures, these interest payments are taxdeductible. One other feature that investors should be aware of is that inorder to increase the equity accounting, interest on the debentures (andindeed the preferred securities) can be deferred and rolled up, generally for atleast five years.

MIPS (Monthly Income Preferred Securities) are a variation on the theme,with income being paid monthly rather quarterly. Sometimes, these areissued out of limited partnerships rather than Delaware Trusts, but while theinstrument for the investor may seem slightly different (and indeed, theinvestor may need to account for these instruments differently), the net effectfor the issuer is the same.

Regardless of why these structures are used, from the investor’s perspective,the exact nature of the internal workings of the special purpose vehicle andthe resulting tax, regulation and/or accounting treatment are not relevant(except to the extent that they may have an impact on the shares). Investorsshould simply focus on the guarantees and status of the instrument that theyhave purchased and, in particular, what security they have in a winding up ofthe parent company. This should allow investors to see exactly where theyrank and correspondingly what credit spread is appropriate.



Convertible capital bonds

The US isn’t the only place where this type of structure has been used and,indeed, in the early 1990s, many UK corporations used a similar idea to issueconvertible capital bonds from offshore (mainly Channel Island) SPVs.However, the loophole was closed in the mid-1990s. Nevertheless, issuershave found other uses for the same structure and, specifically for non-sterlingconvertibles, it has been used to avoid the SDRT (stamp duty) charge, whichis applicable only for new shares issued in currencies other than sterling.

SDRT is avoided because the bonds first convert into sterling-denominatedexchangeable redeemable preference shares (ERPS) of the SPV, which isoffshore and therefore not liable for stamp duty. The ERPS then immediatelyand mandatorily convert into shares of the parent at the prevailing rate andas these as sterling denominated, conversion does not attract stamp.

Figure 29: Convertible capital bond structure

SPVCorp Bondholders

Cash

GuaranteedBonds

SPVCorp Bondholders

Bonds

ERPS

ERPS

Shares

Inter-coloan

Inter-coloan

On issue:

On conversion:


Use of the old capital

bond structure

demonstrates

innovation within the

CB market



An even more recent development has seen the same structure used byUnited Business Media to get round the UK pre-emption rules. The legalargument put forward is that the consideration for the right to convert thebonds into parent company shares is the ERPS and not cash and so theargument concludes that the statutory pre-emption rights of the UKCompanies Act do not apply. This is similar in idea, though different inactuality, to the ‘cash-box’ placing structure also used to avoid pre-emption.The convertible capital bond structure no longer gives deductible equitytreatment for the issuer, but it is an excellent example of how differentstructures can be recycled to meet different needs.

One concern for investors, common to all of these deductible equitystructures, is the added complexity within the documentation. For example,conversion of the capital bond structure goes through an intermediate step ofconversion into the SPV’s preference share capital, which then converts intoordinary shares of the parent. However, it is the documentation of theintermediate preference shares that tells how the conversion ratio will beadjusted rather than the documentation of the convertible bond. In the eventof a change of control, the bond documentation will contain the details of anyinvestor ‘poison put’, but it will be the documentation of the preferenceshares that contains any enhancements to the conversion ratio. Investorswho do not carefully read the documentation may miss out.

Structure now used to

avoid pre-emption

rights



Soft mandatory redemption

One of the key problems from the issuer’s perspective is uncertainty. Whilethe cost of the convertible is cheaper than straight debt, assuming the bond isredeemed and cheaper than an equity issue if the bond is converted, there isno way of knowing in advance whether the shares will be issued or not. Arecent innovation, which has yet to be used with any regularity, at leastpartially solves this problem. Here, the issuer has the right (but not theobligation) to redeem the bond in shares, but unlike with a mandatorystructure, the value that an investor receives is made up to par. The top-up isgenerally in cash, though the redemption proceeds could be topped up withadditional shares. From the investor’s perspective, the value of the bond isunaltered as long as the shares received on redemption can be hedged.

From the issuer’s perspective, the soft mandatory feature really does alter thenature of the convertible. The issuer can guarantee that the shares underlyingthe convertible will be issued, but is then short a net settled put option on theshares. There is also a dividend for interest swap.

Figure 30: The soft mandatory structure

Long stock Net settled

put optionIncome swap


Clearly, the fact that the shares can be issued under any circumstances hasimplications for the rating agencies and effectively strengthens the issuer’sbalance sheet. The issuing company is not obliged to redeem in shares, butcan simply deliver cash to investors upon redemption. This ability to delivercash gives the company great flexibility over its balance sheet, effectivelyallowing the issuer to conduct a share buyback at maturity of the bond.Consequently, the soft mandatory structure gives a lot of flexibility to theissuer and yet seems to take little value away from the investor.

The key question in terms of value is whether the shares that are deliveredupon redemption can be hedged, or whether the mechanism that determinesthe value of the underlying shares (and therefore the value of the cash to bedelivered) contains a look-back option for the issuer. The current softmandatory structures contain no look-backs and so can generally be hedgedand there is therefore no theoretical loss of value to the investor.

Soft mandatory

structure removes

company uncertainty as

to whether shares will

be issued



Ahold soft mandatory clause

Unless previously redeemed, converted or purchased and cancelled as hereinprovided, the Company will redeem the Convertible Notes at their principalamount together with any interest accrued to the date of such redemption onSeptember 30, 2003. The Company may elect to deliver Common Shares pluspayment of a compensation amount (the Compensation Amount) upon thematurity of the Convertible Notes instead of redeeming the Convertible Notesfor cash at their aggregate principal amount together with accrued interest. TheCompany shall exercise this election by giving an irrevocable notice, no laterthan September 15, pursuant to the notice provisions set out herein. Failure togive such notice will be deemed to be an election of the Company to redeem theConvertible Notes for cash at their aggregate principal amount together withaccrued interest.

If the Company elects to deliver Common Shares and to pay a CompensationAmount, the Company shall, on September 30, 2003, deliver the number ofCommon Shares which correspond to the principal amount of Convertible Notesoutstanding divided by the Conversion Price and pay a Compensation Amountper NLG 1,000 principal amount of Convertible Notes which shall be calculatedon the basis of the following formula:

K = NLG 1,000 – (NXT)

WhereK = the Compensation AmountN = the number of Common Shares delivered, andT= the Trading Price

However, under no circumstances will the Compensation Amount be less thanzero.

Source : Ahold 3% 2003 Euro Bond Prospectus

When the soft mandatory clause has been exercised, the investor has sharesplus a put rather than cash plus a call. The shares will be delivered in allcircumstances, but if the stock falls, the investor receives the additional cashpayments under the soft mandatory clause (ie, the investor is compensatedon the downside). Where the company has already announced that the softmandatory clause will be exercised, but where the conversion rights of thebonds have not expired, the investor is best served closing out the stockposition over the averaging period, while retaining (or selling) the stock-settled put.

The final consideration for investors is the impact on the credit. Allobligations under the bond will be at the stated level, including the cashcomponent of redemption. In the event of early redemption, cash has to bedelivered and in the event of default, investors have a cash claim at whateverlevel the bond is ranked (ie, senior, subordinated, etc). Assuming the sharesdelivered on redemption can be hedged, in theory, there should be no impacton credit.

However, many credit derivative contracts (both asset swap and CDS) requirethat the credit buyer can only receive cash on redemption and this means thatbonds with soft mandatory features may not be deliverable against CDSs andmay not be as liquid in the asset swap market. So, even though no greaterrisk is involved to the investor, soft mandatory structures may trade widerthan traditional convertibles by the same issuer as hedging the credit may bemore expensive. Consequently there may be a cost to the issuer in using thesoft mandatory feature.



Other structures

1. CoPay convertibles

2. Bonds with warrants

3. Coupon changes

4. Credit enhancements/repackaging of bonds

5. Event puts

6. Tax/Regulatory calls



CoPay convertibles

‘CoPay’ features represent the second and in many ways the more powerfulpart of the ‘contingency’ revolution that powered the extraordinary growth ofthe US convertible market last year. The individual contingent paymentfeatures can be much more varied than the different CoCo structures, but allhave characteristics that potentially allow them to be classified under the USIRS's Contingent Payment Debt Instrument (CPDI) regulations.

Such classification allows the issuer to claim annual deductions based on thenormalised non-convertible cost of debt (which will be stated in the bond’sdocumentation). Given that many of these bonds are zero-couponinstruments, this is extremely beneficial, especially when coupled with theCoCo structure, as the company will not have to account for any initialdilution and will receive a very substantial tax shield, despite no annualinterest payments. For example, D.R. Horton 0% 2021 USD convertible has aYTM of 3.25%, whereas the company stated that its comparable non-convertible yield would be 8.88% - the CoPay feature gives a very sizeableenhancement to the tax shield.

Figure 31: Example of a CoPay structure

75

100

125

150

175

200

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

No contingent

payment

No contingent

payment

Contingent paymentContingent payment

Trigger price

Accreted bond value

Issue price


However, it is not certain whether the IRS will indefinitely allow CoPaystructures to bring the instruments under the wing of CPDI regulations.Indeed, no official ruling either way has ever been given. It is even possible(though unlikely) that the IRS will act retrospectively, ruling that existingCoPay convertibles should not fall under CPDI regulations. To fullyunderstand the situation, it is necessary to understand the CPDI regulationsthemselves.

‘CoPay’ features

represent the second

and in many ways the

more powerful part of

the ‘contingency’

revolution



The CPDI regulations were introduced to close a loophole that allowed retailinvestors to avoid income tax. Prior to these regulations, by making a fixed-income product’s payout contingent upon some external variable (forexample, an equity index) the actual yield of the product contained a measureof uncertainty and therefore the investor did not have to realise the intereston an accruing basis. However, the IRS ruled that no investor would buy sucha product unless it returned at least the issuer’s normal yield for debt ofcomparable rank. And so the investor became required to recognise incomeat this normalised rate, regardless of whether any cash payments were madeand regardless of the contingency upon which that interest depended.

Conversion rights themselves are effectively a ‘contingent payment’ allowingthe issuer to sell bonds below there normalised yield to maturity and, indeed,exchangeable bonds do fall under the CPDI regulations. However,convertibles were explicitly excluded from the regulations, in particularbecause of the prevalence and success of the LYONs structures within the USmarket. Bringing LYONs under the CPDI regulations would have created largetax deductions for issuers with big (and poorly understood) tax liabilities fortraditional onshore US domestic investors.

The aggressive tax stance being taken by CoPay issuers is that it is theconversion rights have been excluded from triggering the contingencyregulations, rather than a blanket exclusion on convertible bonds per se. Theissuers argue that by introducing separate contingency features into thebond, the convertible then falls under the CPDI regulations. Of course, if theIRS were to rule that the exclusion applied to convertible bonds themselves(as opposed to the conversion rights embedded within convertible bonds),then CoPay bonds would not fall under the CPDI, and the issuers would ceaseto get the favourable tax treatment. However, as at the time of writing, theIRS has remained silent, which would seem to be positive for the structure.

The enhanced deduction taken annually through the CoPay structure is takeninto account at maturity. Consequently, if the issuer redeems the convertibleat its accreted value (which will represent a far lower yield to maturity thanthe ‘normalised rate’ at which deductions for tax have been made), thecompany will make an exceptional gain and will have tax to pay. Of course,the issuer still has a considerable timing benefit and the NPV of tax paid is farlower through the CoPay structure. This advantage increases with the lengthof time to redemption and this may influence call decisions, acting as adisincentive for issuers to redeem CoPay bonds early.

The issuer can also achieve a considerable tax benefit upon conversion.Parity of the bond at conversion is taken as an ‘interest payment’ (even if thecash-out option is not used and the company delivers shares!). Consequentlyif parity is above the accreted value (and investors would not convert if thiswere not the case), this will reduce the issuer’s tax bill. Indeed, if parity ishigh enough to give investors a return greater than the company’s‘normalised rate’, then the company will be able to make an additionaldeduction against tax. From the company’s perspective, the cost of beingshort shares through the convertible’s optionality is reduced by their tax rate(ie, the shares only have a delta of 65% on the upside!). In reality, this meansthat for every 100 embedded call options sold through a CoPay, the issuereffectively gets 35 back from the tax authorities, seriously reducing the cost ofthe optionality sold through the bond.

Convertibles were

explicitly excluded from

the CPDI regulations…..

…. issuers argue that by

introducing separate

contingency features,

the convertible then

falls under the CPDI

regulations



This looks a compelling argument from the issuer’s perspective and, indeed,we estimate that nearly $40bn of last year’s record US domestic convertibleissuance contained CoPay provisions. The most common type of contingentpayment is an additional coupon equal to the higher of the dividend yield ofthe stock or 50 basis points, if the convertible trades above 120% of itsaccreted value. However, some bonds contain additional payments if theshares trade below a specified trigger level (generally 60% of the accretedconversion price). However, the contingent payments do not kick in until afterthe hard call period expires and so the issuer can always avoid them if theyso choose.

Table 2: CoPay Alternatives

Trigger basis Trigger event Contingency payment/ adjustment

Bond price Bond trades above 120% of accreted value Equal to the dividend yield on the stock, or 50 bps,whichever is higher

Stock price Stock trades below 60% of accreted value Accretion rate is increased to provide a YTM in linewith cost of straight debt and issuer makes a cashpayment of 25 bps


Of course, if the issuer can get a tax shield, this has implications for someinvestors. Investors who are onshore (ie, who are liable for US taxation) haveto account for ‘phantom income’ on CoPay convertibles, which leads to anannual tax liability as if they had received a coupon equal to the issuer’snormalised borrowing rate. If the bond redeems, the investor will haveoverpaid tax and so will get a tax credit, but the NPV of the tax credit will beway lower than the tax paid on the phantom income. Also, on conversion, theinvestor will have to pay income tax on any returns above the conversionprice. So the tax treatment for onshore investors is the matching opposite ofthat received by the issuer (and is therefore dreadful).

For this reason, these securities tend to be marketed towards tax-exemptoffshore funds (particularly hedge funds). However, the tax liabilitiesassociated with investing in CoPay bonds are far from certain (especially foronshore European funds) and, in particular, the tax situation that would ariseon conversion seems unclear. As these bonds are a recent innovation withlong maturities, this has yet to be tested and indeed is unlikely to be tested inthe near future.

The contingent interest rules are a US tax regulation that does not apply inother jurisdictions. But there is nothing to prevent foreign companies issuingbonds out of US subsidiaries and most large multinational corporations haveUS tax-paying subsidiaries that can be used. There are certain complexitiesinvolved with this and, specifically, it can create problems for the subsidiaryto get rights over the parent company’s shares in order to match the ‘short’conversion option. Nevertheless, these problems are not insurmountableand, indeed, Roche’s main US subsidiary (Roche Inc) issued the first CoPayconvertible from a European company in July last year.

There are some limiting factors. Firstly, the company must have a USsubsidiary with substantial profitability – CoPays can only save US tax andwithout US profitability, there is no tax to save. Secondly, a consideration ofthe US rules on ‘thin capitalisation’ is needed, as the US authorities restricttax deduction of subsidiaries of foreign corporations that have excessivegearing, effectively preventing foreign corporations from using excessivedebt to repatriate all US-generated profits without paying US taxes.Nevertheless, a substantial number of international and especially European

Contingent payments

do not kick in until after

the hard call period

expires and so the

issuer can always avoid

them

There is nothing to

prevent foreign

companies issuing

CoPay bonds out of US

subsidiaries



issues have the potential to follow Roche and issue CoPay bonds out of theirUS subsidiaries.

Phones and Zones have also used the CPDI regulations to create anexceptionally advantageous tax structure. These are exchangeable securities,with mandatory ‘conversion’ at redemption, effectively giving ‘delta one’exposure to investors. However, the long maturity gives the issuer significanttax advantages, effectively delaying capital gains from the disposal untilconversion. Conversion is generally American, but the investor loses 5% ifconversion takes place before maturity, unless the instrument is called. Theissuer can ‘call’ the bonds early, though the investor still just receives theshares, and the call feature was principally included to ensure that theinstruments received equity treatment.

Phones and Zones also include contingent payment features where the issuercan make ‘stock interest payments’ on the bond at various times during itslife. This amount is deducted from the principal due at maturity (in reality,this has little impact on valuation and is simply a partial early mandatoryconversion). These contingent payments brought the instruments under theCPDI regulations, allowing the issuer to deduct their normalised borrowingrate, greatly improving the timing of tax payments by the issuer and thereforecreating tax NPV gains. However, recent accountancy changes make it lesslikely that these instruments will qualify as equity and so future issuance islikely to be limited at best.

Recent accountancy

changes make it less

likely that Phones and

Zones will qualify as

equity



Bonds with warrants

Some convertibles are issued as bonds with warrants and where the warrantscan be detached, investors will strip the warrants from the bonds and theywill trade separately. Correspondingly, an issue of bonds with freelydetachable warrants should be thought of and indeed has the economics of abond issue with a separate warrant issue. Where the warrants cannot bedetached, the instrument will behave exactly like a convertible and will bevalued as such. However, this does beg the question as to why the bond isstructured in this way.

The recently issued Nestle turbo structure is a good example and can be usedto explain the structure from an issuer’s perspective. Here, differentsubsidiaries wish to issue the different components within the convertible,with the debt portion coming from the US, possibly using a CoPay structureto get favourable tax treatment, while the equity component comes from adifferent subsidiary, often an offshore SPV. Both components are guaranteedby the parent and are then stapled together and sold as a convertible.

The structure itself does not enhance the accounting treatment of the issuer.The advantage to the issuer is that each of the debt and equity componentscan be issued out of whichever subsidiary is optimal for that particularcomponent. Often, this will mean that the debt component will come from theUS (assuming the issuer does not have a problem with the Thin Capitalisationrules), while the warrant will come from wherever it is easiest to get access tothe shares.

Figure 32: Turbo mechanics

Guaranteed Guaranteed

Issue call

warrant

Issue of

note

Issue stapled note

to market

Corp.

US Subsidiary

Corp.Corp.

Offshore SPV

Bank

Source: Source: Deutsche Bank

The bond with warrants structure has no real implications for investors andthese instruments should simply be valued as normal convertibles.

Different subsidiaries

wish to issue the

different components

within the convertible



Coupon changes

An increasingly common feature of the fixed-income universe (particularlyprevalent among telecom names) is the ‘step up’ coupon. Here, the interestrate that an investor receives is increased on set dates or under specifiedevents, or a bond may change from a zero-coupon accreting structure to aninterest-bearing instrument. This feature has rarely been used amongconvertibles, but its increasing appearance in the fixed-income universesuggests that convertible investors should be aware of it.

Telewest 11.375% 2010 USD is a good example of a straight bond thatconverts from an accreting structure to an interest-bearing instrument. Thebond was issued in 2000 at a price of 57.406 and accretes up until February2005, after which the bond pays a semi-annual coupon of 11.375%, thoughthe bond also becomes callable on the same date. This structure is highlysuited to a growth company, avoiding cash outflows until the businessmatures and starts to generate revenue. The call allows the company torefinance and saves it from paying high interest rates after the business hasmatured.

Bonds with step-up coupons dependent upon ratings downgrades havebecome particularly popular among telecom issuers following their inclusionby Olivetti in the debt issued to finance its acquisition of Telecom Italia. Theidea is very simply to protect investors in high credit quality issuers that areusing the balance sheet to fund acquisitions (or in the case of some of theother Telcos, investment in 3G licenses). The basic concept is that if the creditrating as assigned by Moody’s or S&P declines to a specified level, thecoupon rate of the bond increases, enhancing the return to the investor.

However, the problem is that if these clauses appear in a majority of anindividual company’s debt, they can increase the volatility of ratings. This isbecause if a downgrade occurs, the interest charge will increase, damagingthe interest cover ratios and making a further downgrade more likely. And ofcourse, if a further downgrade does occur, this may well trigger further astep-up clause, further weakening the interest cover, putting the rating underfurther downward pressure. The problem for convertible investors is thatoften their bonds do not contain the step-up clauses and so they have theincreased risk of downgrades without receiving the benefit of the couponenhancements.

One area where coupon changes have occurred within the convertible marketinvolves changing the coupon structure of the convertible to gain extra equitycredit. This is feature is far from common, but does occur in a number ofbonds and the recent $1 billion Swiss Re 3.25% USD 2021 provides a goodexample. Here, for the first ten years of the 20-year structure, the bondbehaves like a normal convertible, but after ten years, the conversion rightslapse and the bond switches to a callable FRN with an interest rate of LIBOR+180. The bond should receive some equity credit from rating agencies dueto its long maturity, coupon deferral features and subordinated status.

Step-up coupons are an

increasingly common

feature of the fixed-

income universe

Step-up coupons can

increase the volatility of

ratings



Figure 33: Structure of Swiss Re 3.25% convertible

Soft callwith 120%

trigger

Year 10 Year 20Year 5

Hard call

FRN(Libor + 180 bps)

Fixed CB(3.25%)

Source: Swiss Re 3.25%2011 USD Bond Prospectus, Deutsche Bank

This structure is far from ideal from an investor standpoint and hedging thecredit can be particularly difficult. The best hedge would be to asset swap thebond on a callable basis (but with the investor’s ability to recall the bondlapsing after conversion rights expire). However, while some asset swapshave been undertaken in this name, the market is limited. The only alternativehedge would be to buy ten-year CDS protection against subordinated SwissRe paper, but this would obviously leave residual credit risk with the investorin the event that the bond does not convert or is not called. Effectively, theinvestor is short a credit option struck at 180 bps over LIBOR. Consequently,the asset swap level gives the best theoretical spread to use when evaluatingthis bond.



Credit enhancements/repackaging of bonds

Obviously, one of the key criteria in valuing a convertible is the credit spreadof the issuer. When the issuer is unknown in terms of public debt, investorsoften assume the worst about the company’s credit and this will affect thepricing that the issuer can achieve. However, it may prove that the issuingbank and/or some of its fixed-income clients, or a selection of the company’scorporate banks, have a greater understanding than the wider market andtherefore believe that the debt should be priced more keenly.

Where this is the case, the convertible issue can be repackaged and then soldas an exchangeable. The issuing bank either retains the original creditexposure (at the price it feels is appropriate) or offsets the risk to a syndicateof other banks or selected fixed-income investors. This works well for allparties concerned. The investors can invest in a convertible with a credit theyknow well, the issuing banks successfully sell the deal with the issuingcompany’s credit placed with the right group of investors and from thecompany’s perspective, the convertible is sold and keener pricing is achieved.

A good example of this in practice is the DB/Prada 1.5% Euro CORE bond.Here, the seller of the underlying securities had no public debt and so theright credit spread was not particularly well known in the market.Consequently, the bond was repackaged and sold as an exchangeable withDeutsche Bank credit.

Figure 34: Repackaged bond

Syndication of risk

Public

Convertible

Corp.

Fee

Exchangeable

Cash

Risk Fee

Bank


Numerous Asian issues have launched deals with enhanced credit, oftenthrough a ‘letter of credit’ issued by a bank. This is not an explicit guarantee,but effectively acts like an implicit guarantee. The bank will presumablyaccount for the letter of credit as a contingent liability, but can alwayssyndicate out the risk, should they choose to do so. The mechanism forreceiving payment if the issuer goes into receivership is slightly differentfrom with an explicit guarantee, but in essence, the credit still becomes thatof the bank that writes the letter of credit.

Letters of credit work well and these issues are raised to the rating of the‘guaranteeing’ bank. The credit derivatives markets apply a small haircut tothese structures due to the unusual nature of the documentation, but inpractice, there is little difference between these bonds and bonds that havebeen repackaged as exchangeables. In both cases, the risk is transferred from

The issuing bank either

retains the original

credit exposure (at the

price it feels is

appropriate) or offsets

the risk to a syndicate

of other banks



the investor to the bank (and of course in both cases, the bank will charge afee for this), but with the exchangeable structure, the bank takes the issuer’srisk on balance sheet

Figure 35: Letter-of-credit structure

Syndication

PublicCorp.

Fee Letter ofcredit

Cash

Risk Fee

Bank

Bonds


Finally, some bonds are repackaged despite the issuer’s having exceptionallystrong credits. This is because it is necessary for other elements of the issueand the PECs structure is an excellent example, though it is possible thatTurbo bonds could be sold as exchangeables as well.



Event puts

Conditional puts are becoming more common in issues, with the majoritybeing poison puts, which allow investors to demand early redemption in theevent of a takeover. However, there are some other examples of conditionalputs, often in industries where an operating licence needs to be granted bythe government. Here, the put is designed to protect the investor, for examplefrom political interference. Sometimes these puts have secondary conditionsand, in particular, many puts require that the specified event leads to a creditdowngrade (often to below investment grade); this greatly alters the dynamicof how these puts operate.

Poison puts are particularly common in the US. In theory, they guarantee thatan investor will get at least the higher of parity and par (or accreted value) inthe event of a change of control, though, of course, enhanced conversionrights or an increased offer from the acquirer can raise the investor’s returnseven higher. In some countries (for example the UK), market convention isthat an acquirer should offer at least par and where this is the case, thepoison put would seem to offer little value. However, market conventions areoften non-statutory and therefore poison puts are still advantageous, even inthese markets.

Poison puts seem to be an excellent protection for investors and indeed thisis normally the case. However, there is one problem with poison puts – thepotential acquirer will know of their existence and the cost will be factoredinto the evaluation of whether an acquisition makes sense. Obviously, if thepoison put is only in one convertible bond, its impact will be limited, butoften the provision will be in all public debt, and this is especially true forsecond-line issuers. Clearly, in this case, not only will the cost of theacquisition greatly increase, but also any acquirer will have to finance anyacquisition predominantly in cash. This can be a severe handicap tonecessary restructuring and consequently can prevent companies being takenout if the shares perform badly.

Some of the alternative Telcos in Europe illustrate this very well. Forexample, the Versatel convertibles contain good ‘poison put’ protection, butunfortunately so does all of the company’s straight debt. The equity has fallenso far that a cash bid of Euro 100m would represent an enormous premium tothe current price. However, the cash cost of redeeming all of the bonds wouldbe more than Euro 1.6bn and clearly this will make any potential acquirerthink twice about launching a takeover. Another good example of this is theUK cable industry, where poison puts in the debt of the various companiesput severe hurdles in place, despite the industrial logic of furtherconsolidation.

Some convertibles (and most commonly those issued by privatised andregulated UK corporates) contain regulatory puts. These allow investors torequire the company to redeem the bonds early, but the puts only becomeactive following certain pre-defined triggers. These normally relate tochanges to the operating franchise of the company, often coupled withratings downgrades to below investment grade. These regulatory puts havetraditionally been seen as a support to the credit. In particular, theseregulatory puts have highlighted the connections between the issuer and thegovernment, reinforcing the argument (false in our view) that there is implicitgovernment backing for these names.

Poison puts provide

protection, but can

prevent restructuring

Some of the privatised

UK corporates have

issued convertibles with

regulatory puts



The idea of implicit government credit backing has become increasinglyquestioned over the last year, as demonstrated by significantly wideningspreads at many privatised companies. Nevertheless, the regulatory putfeature would seem to offer some protection to investors. However, webelieve this protection is limited at best. Companies with regulatorydependant puts are by definition subject to significant regulation, which islikely to alter the administrative process compared to normal corporateentities. This is likely to restrict bondholders if the company goes intoadministration and may well prevent bondholders from exercising the putshould it be triggered. Investors should be aware that all straight bondsissued by the company are likely to contain similar restructuring puts and aswith poison puts, this restricts their value. Consequently, we believe investorsshould attach little, if any value to regulatory puts.



Unusual call structures

Legal or regulatory calls can be used in certain cases where the issuer needsadditional flexibility, for example, where corporate activity has almost, butnot quite, completed. The Rhone Poulenc exchangeable into Rhodia providesa good example of this; the bond was sold ahead of completion of the dealwith Hoechst, but was redeemable with a 2% penalty if the Aventis mergerdid not complete. This certainly represented a risk to investors, but as therewere no real obstacles to the merger, this was seen as minimal.

A better precedent from the investor’s perspective is the call used in theDB/Novartis structure. As this transaction was driven by the tax benefits tothe issuer, Novartis naturally wanted to protect itself against any adverseregulatory changes. However, allowing the bonds to simply be callable wouldeffectively remove all the optionality from the investor. Consequently, there isa call structured within the bond that allows the issuer to redeem at thehigher of the accreted value and the market value – giving the investor fullprotection in the unlikely event that this ‘call’ is activated. Obviously, futureissuers may want to include this clause to give increased flexibility. Wherethere is greater risk of this call feature becoming active (ie, where thetriggering event is more likely), we would expect investors to demand amodest premium to be included within the clause.

DB/Novartis regulatory change call clause

Redemption upon Legal or Regulatory Change. The Issuer may, upon not lessthan 30 Banking Days notice in accordance with §9,redeem all, but not less thanall, of the Bonds then outstanding at the greater of (i) the current market price ofthe Bonds, as determined jointly by two independent investment banks ofinternational reputation selected by the Issuer and (ii) the Accreted PrincipalAmount (determined as set forth in §2(4)),if any change or prospective change inthe accounting, tax, legal or regulatory treatment applicable to the Bonds, theShares or any hedging transaction of the Issuer, the Guarantor (as defined in §6)or any affiliate of the Guarantor in respect of the Bonds (including, among otherthings, any derivatives transaction entered into by the Issuer, the Guarantor orany affiliate of the Guarantor with a third party with respect to the Shares)hasoccurred or is likely to occur that would have a material adverse effect on theIssuer ’s or the Guarantor ’s position in respect of the Bonds or the position ofthe Issuer, the Guarantor, any affiliate of the Guarantor or any counterparty inrespect of any such hedging transaction, in each case as determined by theIssuer in its fair discretion (§315 German Civil Code), provided, however, that theIssuer may exercise such right of redemption (x) only after having usedreasonable efforts to avoid such a material adverse effect (including, amongother things, by restructuring any hedging transaction of the Issuer, theGuarantor or any affiliate of the Guarantor),and (y) in the case of a prospectivechange, not earlier than 90 days prior to the effective date of such prospectivechange.

Source: DB/Novartis 0% 2010 Euro Bond Prospectus

Tax calls were a very common feature until the late 1990s, in particular withinEurope, allowing the issuer to redeem the bond early in the event ofunfavourable tax changes. These often related to withholding tax, as manyissuers had contracted to make good any loss to international investors ifwithholding tax were imposed upon their bonds. Tax calls were introduced to



give the opportunity to the issuer to refinance if withholding tax increased thecost of their bonds. Unfortunately for some issues, the loss of optionality dueto the bonds becoming callable was more negative than the effective couponreduction through the imposition of withholding tax, especially for lowercoupon bonds issued in the more recent lower interest-rate environment.

Consequently, when the EU started to seriously consider the imposition ofwithholding tax on eurobonds, this issue became a real concern within theEuropean convertible market. However, the UK appears to have successfullystalled progress on the withholding tax debate and, in any case, the argumentfor existing bonds to be ‘grandfathered’ (ie, excluded from any newwithholding tax regulations) seems to have been won. In addition, almost allEuropean issues over the last three years have no tax call provisions includedand consequently the concerns within the European market have receded andseem unlikely to return. Tax calls do exist in some other jurisdictions (eg,Asia), though the risk of them being triggered seems minimal.



Disclosure checklist (priced as at 26 February 2002)

Company Ticker Price Disclosure

Ahold AHLN.AS Euro 27.27AXA AXAF.PA Euro 21.13Credit Swiss CSGZn.VX CHF 59.65Daimler Chrysler DCXGn.DE Euro 46.17 1,5,6,8Deutsche Bank DBKGn.DE Euro 67.01Energis EGS.L GBp 3.44 2France Telecom FTE.PA Euro 29.45 1KBC KBKBt.BR Euro 35KPN KPN.AS Euro 5.67 8Merrill Lynch MER.N $48.5 2National Grid NGG.L Euro 465.5Nestle NESZn.VX CHF 375.5Novartis NOVZn.VX CHF 62.85 1Panafon PANr.AT Euro 5.76 2Prada na naRailtrack na na 1,2Roche ROCZg.VX CHF 117Swiss Re RUKZn.VX CHF 148 1Telecom Italia TIT.MI Euro 9.26Telewest TWT.L GBp 18.5 2United Business Media UBM.L GBp 557.5 2US Cellular USM.MU Euro 45Versatel VERS.AS Euro 0.55Vivendi Environment VIE.PA Euro 36.69 1

1. Within the past three years Deutsche Bank and/or its affiliate(s) has underwritten, managed

or co-managed a public offering for this company, for which it received fees.

2. Deutsche Bank and/or its affiliate(s) makes a market in securities issued by this company.

3. Deutsche Bank and/or its affiliate(s) acts as a corporate broker or sponsor to this company.

4. The author of or an individual who assisted in the preparation of this report (or a member of

his/her household) has a direct ownership position in securities issued by this company.

5. An employee of Deutsche Bank and/or its affiliate(s) serves on the board of directors of this

company.

6. Deutsche Bank and/or its affiliate(s) owns an amount of securities issued by this company

that is reportable under the ownership reporting rules of a jurisdiction in which this

company’s securities are registered or listed.

7. Deutsche Bank and/or its affiliate(s) is providing, or within the previous 12 months may have

provided, investment services or other advice to this company.

8. Deutsche Bank AG and/or one of its affiliates are advising KPN NV, Netherlands on the

proposed sale of its 44.66% stake in Pannon, Hungary to Telenor ASA, Norway

As of December 31, 2000, Deutsche Bank AG (DBAG) beneficially owns 14.2% of

DaimlerChrysler AG, as filed with the U.S. SEC on Schedule 13G. In addition, DBAG served

as Financial Advisor to Daimler-Benz AG’s merger with Chrysler Corporation and was an

underwriter for Daimler-Benz AG within the last three years.



The information and opinions in this report were prepared by Deutsche Bank AG or one of itsaffiliates (collectively "Deutsche Bank"). This report is based upon information available to thepublic. The information herein is believed by Deutsche Bank to be reliable and has beenobtained from sources believed to be reliable, but Deutsche Bank makes no representation as tothe accuracy or completeness of such information. Deutsche Bank may be market makers orspecialists in, act as advisers or lenders to, have positions in and effect transactions in securitiesof companies mentioned herein and also may provide, may have provided, or may seek toprovide investment banking services for those companies. In addition, Deutsche Bank or itsrespective officers, directors and employees hold or may hold long or short positions in thesecurities, options thereon or other related financial products of companies discussed herein.Opinions, estimates and projections in this report constitute Deutsche Bank’s judgment and aresubject to change without notice. Prices and availability of financial instruments also are subjectto change without notice. This report is provided for informational purposes only. It is not to beconstrued as an offer to buy or sell or a solicitation of an offer to buy or sell any financialinstruments or to participate in any particular trading strategy in any jurisdiction in which suchan offer or solicitation would violate applicable laws or regulations.The financial instruments discussed in this report may not be suitable for all investors andinvestors must make their own investment decisions using their own independent advisors asthey believe necessary and based upon their specific financial situations and investmentobjectives. If a financial instrument is denominated in a currency other than an investor’scurrency, a change in exchange rates may adversely affect the price or value of, or the incomederived from, the financial instrument, and such investor effectively assumes currency risk. Inaddition, income from an investment may fluctuate and the price or value of financialinstruments described in this report, either directly or indirectly, may rise or fall. Furthermore,past performance is not necessarily indicative of future results.Unless governing law permits otherwise, all transactions should be executed through theDeutsche Bank entity in the investor’s home jurisdiction. In the U.S. this report is approvedand/or distributed by Deutsche Banc Alex. Brown Inc., a member of the NYSE, the NASD andSIPC. In the United Kingdom this report is approved and/or distributed by Deutsche Bank AG,London, which is regulated by The Securities and Futures Authority (the "SFA") for the conduct ofits investment business in the U.K. In jurisdictions other than the U.S. and the U.K. this report isdistributed by the Deutsche Bank affiliate in the investor’s jurisdiction, and interested parties areadvised to contact the Deutsche Bank office with which they currently deal. Additionalinformation relative to securities, other financial products or issuers discussed in this report isavailable upon request.No part of this material may be copied or duplicated in any form or by any means, orredistributed, without Deutsche Bank’s prior written consent.

Copyright 2002 Deutsche Bank AG, all rights reserved.

2002EUR05089

Additional information available upon request

Convertible StructuresMarch 2002

Michael O’ConnorHead of InternationalConvertible Research+44 20 7545 [email protected]

Frank Kennedy+44 20 7545 [email protected]

Clodagh Muldoon+44 20 7545 [email protected]

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