Tracking Debentures

With PHONES, companies can issue 30-year debt at 2 percent.


A large cross-holding of another corporation’s equity may be your company’s ticket to cheap long-term debt. Thanks to a new wrinkle in financial engineering, a company can use its cross-holding in another company as the basis for issuing 30-year debt — a kind of “tracking debenture” — at unbelievably low interest costs. These securities are issued at the price of the cross-holding, and thereafter track the movements of the common stock. The investor holds the option to swap the debt for common at any time, and the issuer can exercise the right to redeem at any point. Not only does the investor get the ride on the upside, the downside is guaranteed by the issuer.

This technique is not exactly new. Zero exchangeables have been around for some time. Until this year, however, the maturities sold have been very short term, with about a 5-year limit. Wall Street’s efforts to get issuers really cheap debt, by selling them with 30- year maturities, were unsuccessful. Here’s why: the exchangeable feature is tantamount to a call on the common of the cross-holding.

Convertible-market investors were not enthusiastic about a 30-year call, because, over so much time, they wouldn’t be able to participate in likely dividend gains in the common. To capture additional dividend flow on the cross-holding, the debt holder would be forced to exchange the debt for the cross- holding’s common. Consequently, the debt holder would pay for, but not use, the full duration of the call option.

Merrill’s Solution

Last March, Merrill Lynch cracked this problem. It was the lead underwriter for the first exchangeable, extendable, and callable subordinated 30-year debenture (trademarked PHONES) for cable operator and content provider Comcast Corp. in a transaction that raised $718 million with a 1.75 percent coupon, pegged to the AT&T Corp. stock that Comcast then owned. What made the deal sellable was that PHONES are structured so that there is no premium, and any dividend increase on the common passes through to the debenture holders.

Last April, Tribune Co., a media conglomerate based in Chicago, used an identical instrument to raise $1.3 billion against its cross- holding of 7 million shares in America Online Inc., and paid a 2 percent rate.

Then, last September, Reliant Energy raised $980 million of 30-year paper, with a 2 percent coupon, exchangeable into Time Warner common. Says Phil Jones, a Merrill Lynch managing director and co-head of global equity- linked origination: “The PHONES removed two technical impediments to many previous exchangeables that were unattractive to common- stock investors. The first was dividend uncertainty; the second, underperformance relative to the common.”

By solving these problems, Jones believes, Merrill has helped increase the total size of the convertible market. “The entire convertible market is only $130 billion. These transactions amount to around $4 billion. That is a large size for a new security.”

Telecom Dreams

The latest deal of this type was from Philadelphia-based Comcast, which in October returned a second time and raised 30-year, 2 percent money in a $1 billion issue that tracks against Sprint’s PCS wireless subsidiary. “If you like Sprint PCS as a stock, though it pays no dividend, you’ll love the 2 percent, plus a downside guaranteed by Comcast,” says Bill Dordelman, vice president for finance at Comcast.

Comcast came by these big cross-holdings because of asset sales in the telecommunications and media sectors. It got a chunk of AT&T from the disposition of its share in Teleport, a partnership of a number of cable operators that was designed to thrust the company into the telephone business. The value of the holding had soared from $150 million to more than $2 billion. Similarly, it ceded control of its share of the PCS wireless phone business to Sprint in return for stock.

Thus, two big strategic assets of Comcast had become monetized. Why didn’t it just sell the stock? Because the company wanted to retain ownership as a possible bargaining chip in future horse-trading. “We had a significant business purpose for wanting to continue ownership,” Dordelman observes.

The wisdom of this course was demonstrated just three months after Comcast pioneered this type of security. Comcast entered into a merger agreement with MediaOne’s cable systems, whereupon AT&T barged in and topped Comcast’s offer.

Rather than engage in a protracted bidding war, AT&T and Comcast smoked the peace pipe in a deal in which Comcast used its AT&T stock (some of which was associated with Comcast’s PHONES offering) to purchase from AT&T some of the MediaOne assets it wanted.

Comcast could technically have left the debt issue outstanding–it is a cash-settled instrument, so there is no legal obligation to actually own the tracked stock. But then the company would have been exposed to perilous risk because it would be short a naked call on AT&T stock. So it exercised its right to redeem, paying a redemption premium and swallowing $14 million in underwriting fees– which made a very small dent in the $1.5 billion breakup fee that AT&T paid Comcast.

Comcast’s second visit to the well occurred after MCI WorldCom had announced its intent to buy Sprint, including its wireless operation, for $115 billion. Under the proposed terms of the combination, holders of the Sprint PCS tracking stock will receive a new MCI WorldCom PCS tracking stock, plus 0.1547 shares of the MCI WorldCom common–all of which get passed through to the exchangeable debenture holders.

The Buyers

Who are the main buyers of these securities? Dedicated convertible funds typically take in about three-quarters of an issue. Equity income funds are not big players, because they prefer the 6 and 7 percent yields that mandatory convertibles earn.

Then, too, there is a sprinkling of individual investors who are attracted by the downside protection. “If the stock goes to zero, at maturity an investor will enjoy a full return of principle. Whereas if that happened and you’d bought the common, you’d come away empty- handed,” says Dordelman. “The investor also gets enhanced yield vis-√†-vis the common. And we get funding at very attractive rates.”

Another active class of buyers are hedge funds, in part because the zero premium, together with the coupon, allows them to fully hedge positions and get good returns with little capital at risk. Such an investor is Fort Worth¬≠based Q Investments, which has $3 billion in assets under management. “We don’t expect to get any home runs out of them,” says president Geoffrey Raynor, “but they do give us a good single.”

From the issuer’s perspective, there are some interesting tax angles. Comcast will defer any capital-gains taxes on the 13.9 million shares over the life of the debenture. More ominously, the Treasury Department has said that PHONES-like deals are being closely studied. They have raised questions of whether these issues perhaps represent a constructive sale of the underlying stock. If so, the issuer should have capital-gains taxes to pay.

Meanwhile, there are likely to be a number of similar transactions in the coming months, some monetizing more of Sprint PCS. Comcast still has roughly 29 million additional shares of Sprint PCS, which are not associated with its recent exchangeable offerings.

Liberty Media has 100 million, and Cox, 70 million. At a price of $75 a share, that means there is $18 billion of equity that could be monetized. Not surprisingly, these companies are being barraged with proposals for PHONES- like deals from every firm on the Street. But that is not all. Hundreds of companies have cross-holdings of Internet, telecom, and media stocks that could be utilized. Tribune, for example, could do a third deal using its equity in Excite, iVillage, The Learning Co., and Peapod.

These securities are likely to catch on. According to Merrill Lynch’s Jones, “The classic complaint against exchangeable debt instruments has been, ‘If I think the stock is going up, I will buy the stock and do better. If I own the exchangeable debt, I won’t profit as much, because of the premium.’ But by crafting an investment vehicle with zero premium, there can be no significant underperformance. So, with $4 billion issued since March, I think this security is off to the races.”

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