New CoCo rule may be a "pothole" for issuance, but market observers say it's not a huge deterrent

By Ronda Fears

Nashville, July 7 - While a new accounting rule requiring issuers of convertibles with contingent conversion features to estimate potential dilution to reported earnings per share might be a bump in the road for issuance, which is already lagging 2003, it is not a major disincentive, market participants said.

"This is just a little pothole in the vast highway we're building for convertible securities and more efficient capital structures," said Richard Ng-Yow, co-head of convertible origination at UBS Investment Bank.

"First we will fight the change because it is not justified. Second, if approved, we will take corrective actions [which, he added, would be a matter of wait and see]. Third, if approved, we adjust and customize just as the convertible market always has."

Certainly, this issue, which just cropped up, is not behind the lagging issuance figures to date.

Moreover, market sources say there are far more ominous factors impacting convertible issuance, chiefly rising interest rates and the general ambiguity about the economy. Presently, convertible issuance year to date stands at $32.35 billion versus $62 billion in the same time frame last year, although the number of deals this year has been 221 compared with 209 a year ago.

"I think, on the margin, some issuers that came last year, attracted by a number of factors, would not do so without the CoCo structure, but we don't know what new developments are impacting the market," said Venu Krishna, head of U.S. convertible research at Lehman Brothers.

"So long as the convertible market is competitively priced, we will remain an active and healthy means for raising capital. The smaller, non-investment-grade companies will still be needing to raise money, although a few of the investment-grade issuers may be detracted."

Krishna and Lehman's tax and accounting analyst Bob Willens held a conference call on the matter Wednesday. While the analysts in a report Tuesday said passage of the new rule is highly likely and could take place in the next six to eight weeks, Krishna said it now looks like the time frame could be much longer. Lehman's convertible research team first looked at the matter in mid-September and again in late January as rising stock prices increased the prospects of the CoCo triggers being hit.

CoCo proposal pending

The proposal, from the Emerging Issues Task Force, is pending with the Financial Accounting Standards Board. The task force meets again in late September, and there could be further comments on the matter that could sway their recommendation.

The huge role of CoCo convertibles is evident.

Issuance data compiled by Prospect News, excluding issues by investment banks exchangeable into another company's stock, shows that so far this year $18.35 billion or 61% of the $30.19 billion of new convertibles has used the CoCo structure.

Over the past year, CoCo deals have made up between 41% and 96% of the dollar volume in any given month.

Lehman's analysis shows that 134 convertibles with contingent conversion features caused a dilution of 5% or higher when the if-converted earnings per share methodology was applied. Also, where issuers have multiple CoCo convertibles outstanding - 30, in all - the dilutive impact will be additive.

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