Salomon: Looming puts a serious matter, but not a serious crisis for convertible market

By Ronda Fears

Nashville, Tenn., Jan. 2 - The short-dated puts that became the rage with the high-premium zero-coupon convertibles dominating issuance over the past 15 months or so seemed to fill the bill at the time, but a Salomon Smith Barney report Wednesday suggests the situation poses very serious complications for the market - although the convertible analysts do not believe there is a serious crisis brewing. The magnitude of the situation amounts to some 8% of the convertible market represented by issues with puts coming due in 2002.

"From the issuers' perspective, these zeros provided low-cost, tax-efficient, and EPS-friendly financing. From the buyers' perspective, these largely investment-grade zeros made sense due to their defensive attributes, enhanced by the puts, in the wake of weak equity markets and credit concerns against the backdrop of a slowing economy," said Salomon convertible analysts Venu Krishna and Adrian Miller in the report.

"Now, however, market conditions have grown steadily worse. Credit concerns still loom, defaults are hitting record levels, the economy is officially in a recession, access to capital has become tougher, and to top it all off, we've had some celebrated blowups. Also, those short dated puts on a host of converts are coming to roost. For issuers, the timing couldn't be worse. For investors, it's time to take notice and reassess the associated risks and rewards.

"While we do not intend to strike an alarmist note regarding the issue of looming puts, we also believe that the matter is serious enough to warrant some thought and analysis due to its sheer magnitude. The very fact that the convertible market has experienced a fair share of high-profile blowups is reason enough to be on the lookout for the next landmine. In addition, recent market events have brought to the forefront a few harsh realities that are worth pondering upon in light of these looming puts; stock prices can unravel in a fairly short time span, market capitalization is not necessarily a barometer of financial soundness, and balance sheets may not fully illuminate all the relevant financial issues, to name a few."

In the final analysis, the analysts said they "do not think the impending puts present a serious crisis for the convertible market."

According to the Salomon estimates, 33 converts representing 32 issuers have over $17 billion in puts that will become exercisable by investors during 2002. The value of the puts represents over 8% of the market value of the U.S. convertible market as of the end of November. In addition, the analysts estimate that around $22 billion in puts are coming due in 2003 via 39 issues, excluding the defaulted AMF Bowling 0s, the At Home 0s, and Sunbeam 0s issues that had puts coming due in 2003.

The issue of looming puts has now taken an added sense of urgency, the analysts said, since the economic and business environment has deteriorated substantially since Sept.11. In addition, market worries about leverage, especially following recent blowups such as Enron Corp. have put increased focus on corporate balance sheets and access to liquidity.

Scrutiny has been amplified because of the record level of high yield corporate bond defaults in 2001. Through Sept. 30, defaults have already hit a one-year record of $44.9 billion, excluding the California utilities that were investment grade as of year-end 2000. In addition, the steep rise in ratings downgrades, especially from investment grade to junk, has made access to liquidity for a number of companies a lot harder and more expensive, the analysts noted.

Against such a backdrop, the specter of large puts looming on the horizon has the potential to drag companies into a tight spot. In fact, this is already happening, although some companies in these situations like Calpine Corp. and Solectron Corp. have managed to address them at least for the short term.

"Interestingly, there is no magic yield to put or return on capital threshold (for a particular credit rating), which drives the decision of convert holders regarding a put exercise. Where the underlying stocks are significantly below their initial issue conversion prices, there is substantial certainty that the put will be exercised," the analysts said in the report.

"However, in essence, the decision boils down to this: what is the convert worth a day after the first put date? If the convert is deemed to be more valuable than the first put price after the first put date, the holder will not exercise the put. As simplistic as it sounds, the focus now shifts to valuing the convert. That in turn is driven by the general level of interest rates, credit spreads, stock volatility, and the stock price."

In the 32-page report, the analysts identified a few red flags that investors should keep track of in converts where puts are coming due. While each of the red flags may not necessarily point to a danger signal in itself, the analysts said a combination of the factors and issuer-specific circumstances have the potential to place companies in a tight spot.

Red flags include refinancing dependency or the viability of the issuer, size of the put, cash-pay only puts, serial issuers of put embedded converts, excessive leverage, a situation where no default or asset swap market exists, situations where the stocks underlying the put representing a large percent of float or trading volume, uncertain or borderline investment grade credits, lack of any saleable assets and inducement driven secondary market effects.

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