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Educational Programming Video

The Value Line Convertibles Survey
Program 5: Zero-Coupon Convertibles

In an earlier session, we discussed the fact that traditionally convertibles offer higher income than their underlying common stock, have priority over common shareholders to the company's assets, and are of higher investment quality. Of course, these are some of the main ingredients for the lower risk inherent in this type of investment security. There are other, actually many different types of convertibles. In this session, we will discuss convertibles that pay no interest. They are called zero-coupon convertibles.

Zero coupon bonds, otherwise known as Liquid Yield Option Notes (LYONs), were introduced in 1985 by Merrill Lynch. Although their popularity was low in the initial years, zero-coupon convertibles now account for about 11% of the total convertibles market. Zero-coupon bonds are issued at a deep discount from par and, in almost all cases, include a "put" feature which enables holders, at their option, to redeem the bonds on pre-determined dates at set prices. Typically, these bonds can be redeemed at five-year intervals for either cash or a combination of cash, stock or notes. As the name implies, zero-coupon bonds pay no cash interest. But, an issue's original yield to maturity (which is determined by the issuer when the convertible is initially marketed) reflects the rate of interest that will need to be compounded and accrued from the discounted price at issuance to reach the bond's face value at maturity.

Like other convertibles, zero convertibles can be exchanged for a specific number of common shares in the issuing company. Unlike other convertibles, however, the conversion ratio of a zero-coupon bond is not fixed, so that the effective conversion price increases each year as the bond appreciates towards its ultimate redemption price. In contrast, regular coupon bonds have a fixed conversion price and a conversion ratio that will only change due to certain events-for instance, a stock split, a stock dividend, or spin-offs that occur within the underlying company.

LYONs offer unique advantages for the issuer: There is no cash outlay of interest payments until the bond is "put" or reaches maturity. Nevertheless, for tax purposes, the issuer can deduct the implied interest expense against income as if paid thus reducing tax payments and enhancing cash flow. Since the conversion price rises every year by the imputed interest rate, dilution potential is reduced. Furthermore, if the bond is converted, the company swaps debt for equity without any cash layout.

From the buyer's perspective the accrued interest (implied) is effectively reinvested at the stated yield to maturity for the life of the bond. The time to maturity can be shortened because of the put option at five-year intervals. The put price will add support to the price of the bond if interest rates rise.

Like other convertibles, zeros will participate in the appreciation of the underlying stock. They were once thought to be immune to redemption calls because of the tax advantages to the issuer but that has not been the case in recent years.

Although the put feature on a zero can be attractive and viewed as the "yield to worst" (minimum expected return), not all puts are created equal. There are two types of puts. A "soft" put can be redeemed for cash, stock or notes or a combination of all three at the company's discretion. Though the market value of the combination on the put date must equal the put price, there is no guarantee that by the time the combination of securities is delivered to your account, they can be resold for at least the same value later. A "hard" put is payable only in cash. Needless to say, a hard put is more valuable than a soft one, and a bond with a hard put will usually command a slightly higher premium. Unfortunately, most zeros are issued with soft puts.

Years ago, taxes on the accrued interest of zeros would be paid at maturity. Now, taxable accounts must pay income tax on the imputed interest each year, even though there is no actual cash payment. This is an obvious disadvantage to the holder, as opposed to the company, which is getting a tax benefit. In addition, whereas holders of coupon bonds can assume an element of ownership in a company if the interest payment is missed, zero-coupon bondholders have no such claim.

If the company gets into financial difficulties, the holder of zeros must await default at a put date, or at maturity, to gain some control.

At the right price, zeros can be very attractive considering the returns relative to their risk, which in general, is lower than coupon-bearing bonds, due to the put feature adding to their downside protection.

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