On the morning of January 24th, 1992 Home Depot Corporation surprised the convertible bond market when the terms of its fourth convertible bond financing were made public. Home Depot (affectionately referred to in trading rooms across America as “Home Dog”, a nickname created from “HD”, its New York Stock Exchange ticker symbol) had successfully placed and subsequently converted to stock three previous convertible bond deals as it financed its breathtaking growth into one of the country’s premier retailing success stories. Home Depot’s share price had zoomed from a split adjusted $.04 per share at the time of its 1981 IPO to over $64 by its fourth successful foray into the convertible market.

The stellar returns to investors in both the Company’s shares and the bonds convertible in those shares permitted the Company to dictate the terms on its new convertible financing. The feature that surprised the market that morning — and unknown to observers at the time, ominously planted the seeds of financial stress for hundreds of young companies that would naively follow in its footsteps — was a record-breaking, and short, five years to maturity.

The convertible bond market has no governing body requiring standardized terms as for the options marketplace. Traders regularly need to read the lengthy indentures, or bond contracts, governing the terms and conditions of each individual bond they trade. The only significant industry-wide gathering of convertible professionals is a popular annual crab feed held each September at a major investor’s home in Santa Monica, California. Some quirky convertible bond provisions are even colorful enough to make it into the mainstream press. Business Week once ran a full-page story describing the tricky “screw clause” lurking in some convertible bond indentures.

Why then, did the most successful and innovative corporations in America such as Home Depot repeatedly turn to such an arcane market to finance their rapid growth during one of the biggest stock bull markets in history? The answer: cheap money and lots of it.

Convertible bonds carry low interest rates and are convertible into stock at prices set far above the issuer’s share price. Home Depot’s 4.5% interest rate was below even that of the United States Treasury. The bond’s conversion terms gave investors the right to buy Home Depot’s stock at $77.50 per share, more than 20% higher than it was quoted that morning on the NYSE. Perhaps most enticing to Home Depot was the size of the deal: $805 million of cash in the bank after just a few days of meetings with prospective investors.

“So what’s the catch?” a wary outsider might well ask. It’s simple: if investors decide not to convert to shares, there is one short, clear and unambiguous clause written into every single bond contract — the requirement that the company return all the money to investors in full, in cash, incontrovertibly, on the day the bond matures.

A common theme among the rapidly growing convertible issuers of the late bull market was the need for the permanent equity capital that would be created upon the conversion of the debt into shares. Another theme that grew more prevalent as the stock market rose ever higher was management’s unshakable belief that their share price would soon rise well above the bond’s conversion price and investors would certainly convert the debt to stock. As long as the issuer’s stock price is above the conversion price by the maturity date, the debt is converted and the cash does not need to be repaid.

The bull market that began in 1982 was just gathering steam in 1992, with the Dow Jones Industrial Average barely past 3,000 in its run from 1,000 in 1982 to its peak of 11,750 in early 2000. Issuers like Home Depot had good reason to be confident. In fact, investors in convertible bonds actually expressed concern that the rapid rise in the share prices of these issuers was causing their bonds to be called away and converted into stock too quickly for them to earn much in interest payments. They demanded, and received, a “hard no-call” period of up to three full years during which time the issuer was prohibited from forcing the conversion to shares regardless of how far above the conversion price the stock traded.

A fuse is lit on a financial time bomb each time a company issues a convertible bond. The issuer’s stock price must rise above the conversion price after the hard no-call period, but before the due date, or they face repaying the debt with cash — cash they may have already spent. The primary variables that determine the outcome are the issuer’s future share price and the amount of time provided for conversion after the end of the hard no-call period and before the due date, as described in the bond’s indenture.

As one might expect, the typical time to maturity in the uncertain early days of the bull market — when stocks were not believed to always go up — was a lengthy twenty-five years. And the no-call period was normally only one or two years. Many bonds then included a feature called a “provisional soft call” which allowed the bond to be converted as soon as the stock traded a certain amount above the conversion price, even if it occurred only a few months after the issue date. Seasoned financial managers in that era had lived through almost fifteen years of flat or down markets and wanted plenty of time to convert their debt to equity before triggering the cash repayment obligation.

However, on July 25th, 1990, after eight bull market years of ever-rising stock prices, the very last convertible subordinated debenture with twenty-five years to maturity rolled off the printing presses and the typical convertible bond term jumped back, virtually overnight, to only ten years.

Issuers found that the cost of the extra and unused conversion runway unnecessarily raised their interest costs and depressed quarterly earnings per share. Gone as well was the use of the word “debenture” — the delightfully erudite-sounding name for twenty-five year convertibles. The informal but widely used name for the new shorter dated paper, “bullet”, was perhaps an unintentional foreshadowing of their greater inherent risk to issuers. While issuers after 1990 typically had just seven years between the expiration of the three-year no-call period and ten-year due date to convert their debt, they were to be seven very fat years.

For the investor, a convertible is like a stock that earns interest but also carries an ironclad promise: the investor’s money will be returned in full on the due date if the investor chooses not to convert the bonds into stock. The investor is betting that the stock price will rise far above the conversion price and provide a big capital gain upon conversion to stock — a common occurrence during the long bull market. The investor’s goal is to earn best of stock-like returns if the stock goes up, or bond returns from the interest income and the “money-back guarantee” if the stock goes down. Much of the guesswork involved in picking the stocks that will go up could be simplified: just invest in convertible bonds, convert the winners while collecting periodic interest payments, and take your money back on the losers.

In fact, the process of investing in convertibles became even more removed from the issuer’s fundamentals as some astute traders found that they could almost entirely eliminate the uncertainty in stock picking by selling some of the underlying shares short in a complex strategy called convertible arbitrage. A properly designed convertible arbitrage portfolio usually provides a consistent and lucrative return, regardless of whether stock prices go up or down. The “hedged” arbitrage investors underperformed the best stock pickers during the bull market, but gained a loyal following among wealthy and sophisticated skeptics looking for a respectable but market-neutral return during the heady days of the long bull market.

If this hedging away of stock market risk by selling short solved one investment problem it quickly created another: how to value the esoteric conversion provisions of the multitude of dissimilar bonds trading in the market. This was one area where advanced technology was embraced by the convertible market. The breakthroughs in Nobel Prize winning option pricing theory were quickly adapted to the option-like features of a convertible bond. Valuing the complicated and idiosyncratic convertible bond terms and understanding the prospects of the rapidly growing companies that issued them could be reduced to punching just two key numbers into a complex mathematical model.

With their new tool, convertible traders began debating credit spread and stock volatility assumptions as “spread” and “vol” became the driving investment themes in the convertible industry. The models instantaneously spit out the theoretical “fair value” of the bond as well as “the Greeks” — gamma, vega, rho and, most useful of all, delta, the percentage of shares to be sold short to be perfectly hedged.

The advanced option pricing mathematics first developed by Professors Fischer Black of the University of Chicago and Myron Scholes of MIT — later co-founder and principal of the ill-fated Long Term Capital Management hedge fund that nearly brought the global financial market to its knees in 1998 — were nearly perfect for the simpler and shorter term contracts in the option market. However, the assumptions required a sometimes decade-long forward estimate of how capable the companies would be to repay interest and principal and how volatile their share prices would be.

While the credit spread and share price volatility of a young company could never be known with any real reliability, what could be known with great precision was that “in the model” shorter maturities and longer periods of hard no-call were always worth more. The difficulty in forecasting the elusive “spread” and “vol” variables was drastically eased as the typical maturity shortened to ten years, then seven and then five, as Home Depot ushered in the new era of bull market convertible bond finance.

The success of the convertible hedge funds in attracting assets during the bull market was due to the growing number of investors attracted to low double-digit returns not correlated to the potentially overvalued stock market. The balance of power in the convertible market shifted decisively in the late 1990s to the hedged convertible arbitrageurs who began to dictate the very restrictive structures of short maturities and lengthy hard no-call periods in the new issues they bought.

By the late 1990s the bull market was roaring and the typical newly-issued convertible bond had only five years to the due date and included three full years of hard no-call. Issuers of those restrictive securities were so confident that their stock market fortune would not run out they were unconcerned about not being permitted to force conversion for three years. The first quarter in which these issuers could force conversion was the thirteenth quarter after the bond was issued. In those euphoric days no one lost any sleep over the contractual requirement to pay back all that money in just another two years. For a convertible issuer in the late 1990s, what could possibly go wrong?

What could go wrong was to see the stock price soar far above the bond’s conversion price during the irrational exuberance of the late stages of the bull market, yet still be prohibited from converting the debt to permanent equity by the hard no-call provisions they themselves had written into their own bond contracts.

What followed as the market declined in 2000, 2001 and again in 2002 was painful for those issuers of shorter-dated, hard no-call convertible bonds who stared in disbelief as their share prices plunged far below their conversion prices — a condition referred to in the convertible market as a “hung convertible.” However, it was a wonderful time for the convertible hedge funds that had shorted the issuer’s shares. The profits from their shorts offset their losses on the bonds, allowing them to pass the ultimate stress period of market neutral investing with flying colors.

The precipitous decline in the stock market after the bubble burst cemented the convertible hedge fund’s dominant position as the arbiter of convertible bond structures. Convertible arbitrage assets under management are reported to have ballooned from six billion dollars in 1999 to almost thirty-five billion dollars today. Traders now say that in many new convertible deals fully two-thirds or more of the bonds are placed directly with these short selling hedge funds.

Redback Networks was as hot a company as hot got during the bubble. They provided broadband networking hardware to a market that was supposed to grow at exponential rates far into the future. Redback went public on May 17, 1999 at $23.00 per share and had soared to the breathtaking stock price of almost $400 just ten months later when they chose to take advantage of the seemingly quick, easy, and cheap money offered by the convertible bond market.

On March 24, 2000, Redback’s shares were trading at $310.125 and the conversion price on their new bonds was set with three decimals of precision at exactly $381.454. The new bond’s unusually lengthy seven-year bullet maturity actually looked downright conservative compared to the even shorter five-year standard set by Home Depot. The company added a “wrinkle” to help reduce the additional interest cost: agreeing that for another year after the end of the three-year hard no-call period they would not force bondholders to convert to shares unless their shares traded at least 40% above the $381.454 conversion price — the nose-bleed inducing threshold of $534.04.

Were investors worried about buying a half a billion dollars of debt issued by a company with less than $65 million of trailing 12-month revenue and just one penny of reported earnings per share? No — not if you could sell those very shares short at that lofty price, be fully hedged, and actually make money regardless of where the stock subsequently traded. As for Redback, were there any concerns that all that cheap money might have to be paid back in seven years? All they had to do was achieve a market valuation in excess of $40 billion in three years when the hard no-call expired. For a stock that had just raced from $23 to almost $400 in less than a year, it seemed only too easy.

While Redback Networks was able to nearly mimic Home Depot’s trailblazing convertible pricing terms, unfortunately, they were not even remotely able to mimic its equally trailblazing growth in revenue, operating cash flow, and share price.

Three years later, on April 1, 2003 — the date the bond’s hard no-call forced conversion prohibition expired — Redback Networks’ split adjusted stock price closed not at $1,000 per share, nor at the required $534.04 per share, nor anywhere near its price at the time of the 2000 bond deal, nor even near its $23 IPO price. On that aptly named April Fools’ Day, Redback Networks’ stock price closed at exactly sixty cents.

Seven months later, burdened with an operating business in a tailspin and a huge convertible bond that could never possibly convert to equity, Redback filed a pre-negotiated bankruptcy package that — in return for retiring all that “cheap” debt — handed the convertible bondholders almost complete ownership in the company that had been worth over $23 billion at the time the bonds were issued.

Is Redback Networks an extreme example? Of course. But today, even after the 50% rally last year in the NASDAQ, there are many companies who have just a couple of years until the due dates of their convertible bonds — bonds whose terms require their stock prices to appreciate hundreds of percentage points before they can convert to equity.

Is a prepackaged bankruptcy filing the only alternative for these companies? No. Many issuers are now turning to the capital markets to raise money at a cost far higher than contemplated in their original bond agreements, paying off the old debt with new, more expensive cash. Others are choosing to renegotiate the terms of their original bonds in exchange for new bonds with terms that may be easier to see convert to shares.

In a bond-for-bond exchange transaction the issuer offers new bonds that allow additional time before the debt needs to be repaid and a new conversion price much closer to the current market price. The combination of the reduced conversion price and the inclusion of the now little-used but effective provisional soft call feature can provide great comfort that the debt can soon become the permanent equity the company originally sought. In return, the bond owner is generally willing to reduce the debt owed by the company, extend the cash due date, and sometimes even provide additional fresh cash to help fund operations.

The big drawback is that an exchange offer is a protracted and seemingly too-complicated process. Many companies that could benefit hesitate while waiting for an opportunity to execute an easier capital markets refinancing. Unfortunately, the clock on that “due date time bomb” ticks while the opportunity wanes — the nearer the cash due date looms, the more the issuer’s negotiating position erodes and bondholders’ willingness to make concessions fades.

With today’s record low interest rates and highly volatile stock market there is a voracious appetite for newly issued convertible bonds. Many companies are able to tap this market not in weeks or even days but in just a few hours of telephonic marketing, after which deals can be wildly oversubscribed. Coupon rates on many newly issued convertible bonds have plunged to virtually nothing — the latest vernacular being a “no-no”: no coupon rate and no yield to the investor. Pushing the comedy of no-nos to farce, several companies, Warren Buffett’s Berkshire Hathaway among them, have recently issued convertible bonds with negative interest yields. The lender actually pays the borrower interest for the privilege of loaning them money.

The convertible bond market has always been a dependable provider of capital to rapidly growing companies. Issuers who thoughtfully and pragmatically design the terms and conditions of their convertible bond indentures to match their strategic and operating prospects can hit pay dirt over and over again, raising hundreds of millions or billions of dollars of low cost capital to propel their growth. Home Depot’s groundbreaking five-year bond deal converted to equity within days of the expiration of the three-year hard no-call period. The still rapidly growing retailer went on to issue a fifth convertible offering, raising a grand total of over $2.5 billion of convertible capital.

The challenge for the issuer is curbing its natural motivation to push the convertible’s very visible interest cost to the lowest possible rate at the expense of materially reducing the much less tangible probability of a conversion. If the debt never converts to equity, the realized cost of capital can turn from the cheapest to the dearest. A prudent and time-tested convertible financing strategy is to balance both price and structure to reliably achieve the ultimate goal: allowing the debt to comfortably convert into permanent equity well prior to the due date.

In this sobered and battle-scarred post-bubble convertible market, how much breathing room do companies now choose to build into their bond indentures in order to secure conversions of their debt into equity? Has the recently and vividly proven value of leaving plenty of time to convert debt to permanent equity been incorporated into the latest convertible bond deals?

Unfortunately for shareholders who may eventually see their stakes reduced or handed over entirely to convertible investors, the typical maturity remains at five years. Further, today many issuers — aided by the illusion of mathematical accuracy of the now ubiquitous binomial convertible bond pricing model — have discovered that extending the hard no-call period all the way to five years to match the bond’s five-year maturity due date can further lower the interest cost of their prospective debt issue. The binomial convertible model accurately calculates the exact number of basis points the coupon cost can be reduced and the exact number of pennies the conversion price can be increased with the hard no-call “bullet” structure so that a new bond just meets the prospective investor’s “fair value” test.

The amount of runway to convert the debt to stock the typical issuer now chooses to write into its convertible bond indenture… all of about ninety minutes on the morning of the maturity due date.

The PhDs in charge of programming the sophisticated binomial models could — but do not — offer a function for calculating the probability that these shorter-dated hard no-call bonds end up as “hung converts.” Perhaps it is because the answer would be too discouraging to prospective clients. More likely it is because the answer does not need a PhD to figure out: the probability is high.

The issuers who focus solely on minimizing the cost of their convertible bonds miss the obvious. The value of issuing a convertible bond is to raise cheap cash that can easily and reliably become permanent equity capital. As Irish playwright and author Oscar Wilde observed in his 1891 novel The Picture of Dorian Gray:

“Nowadays people know the price of everything and the value of nothing.” — Oscar Wilde, The Picture of Dorian Gray, 1891