Stanford paper shows tax shield is strong incentive for convertible issuance

Nashville, Tenn., March 28 - A study from Stanford Graduate School of Business discovered what many in the convertibles world have know for some time - that the tax advantages of some convertible structures are a magnet for issuers.

"Among those who suggest that they really like convertible bonds, there's no one who says, convincingly, that he's getting a bargain when he buys them," Darrell Duffie, a finance professor at the Stanford Graduate School of Business, said in a press release from the university on Thursday. As for the issuer, he noted that the option component of a convertible means it may have to give away stock in the future, thus diluting earnings per share.

The rise of convertibles issuance being fueled partly by tax advantages was the subject of a study by two second-year Stanford MBA students Jen Bergeron and Cheryl Frank for a finance class co-taught by Duffie and Kenneth Singleton.

The students examined the case of Alza, a pharmaceuticals firm based in Mountain View, Calif., which issued a 20-year convertible bond in 1994. Like many others, the Alza convertible includes a provision allowing the issuer to call the bond before maturity and thus force conversion. If the issuer exercises this call provision when the market price of its stock is rising well beyond the conversion price, investors would be virtually certain to opt for conversion into equity, rather than the cash.

However, the researchers observed that firms often choose to keep their convertibles alive, as was the case with Alza. At the first call date, July 1999, the conversion price was $17.69, which was still higher than the prevailing stock price. However, from April 2000, the convertible was consistently in the money for more than a year:

At its peak, Alza stock traded at 144% of the bond's conversion price. Yet, Alza did not exercise a call on the bond.

Bergeron and Frank suggest that the most compelling reason is the tax shield provided by the bond. The bond has a yield-to-maturity of 5.25% but is a zero-coupon bond, so no annual interest payments are paid to investors but accrete by 5.25% each year.

The issuer can write off the year-to-year accretion value as an interest expense. Thus, in 2000, Alza expensed $22.7 million of interest on this debt. At a tax rate of 35%, it was able to retain almost $8 million in cash, the students noted, shielding this amount from the taxman's grasp.

Of course, there is no guarantee that the bond will continue to be in the money indefinitely. The issuer must weigh the tax incentive for not calling the bond against the value of exterminating the convert option by calling it.

In this case, it seemed the bond was so deeply in the money that Alza did not envisage much likelihood of ever having to pay out the cash representing the accrued interest; it has until 2014 to call the bond, if investors do not convert first.

There are tax implications for bondholders, however.

The interest expense that is treated as a tax write-off by the issuer must be declared by investors as interest income even though, in the case of zero-coupon bonds, this income is not realized in cash. Investors need to price in this tax when buying the bonds. However, many buyers of convertibles are offshore, or otherwise tax-exempt, investors in hedge funds.

"It could be that convertibles have been so popular because their tax advantages are so distinct," Duffie said.

"In other words, the Internal Revenue Service may be subsidizing both the investors and the issuers of convertible debt."

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