Contingent Payable Converts
Contingent interest payment (CoPa) features were introduced in 2001. The first security to carry this feature was the $829m Danaher 0% due 2021 senior note that was issued in January 2001. Holders of the converts would receive an incremental interest payment if the underlying stock reached a predetermined level (usually 120% of conversion price).
Incorporating the CoPa feature allows the issuer to treat the convertible as a Contingent Payment Debt Instrument (CPDI) for tax purposes. Any debt instrument whose payments are uncertain in the amount or timing being dependent in another event can be classified as CPDI. By treating the security as a CPDI, the issuer gets substantial tax benefits. This feature has been rare in new converts, but still exists in older ones.
Lehman published a report titled, “Grappling with call risk in CoPa converts” on 3/18/04 that does a good job of explaining the concept. Some of that material is incorporated into this post.
The benefits result from the fact that, for tax purposes, the issuer gets to accrue interest expense at a comparable (non-contingent) straight debt rate (i.e., with similar ratings, ranking, maturity, and the like) rather than the stated yield to maturity (YTM) rate of the convertible with the CoPa feature. Since the comparable rate is, in almost all cases, greater than the stated yield of the convertible, it results in tax shield benefits to the issuer. Clearly, the issuer maximizes the value of the tax shield when the spread between the stated YTM of the convertible and the CPDI rate is the widest.
Assuming that the convertible remains outstanding through maturity, and principal is repaid at maturity, the issuer would be required to reverse the additional/incremental tax shield benefit the issuer received throughout the life of the security. The additional/incremental tax shield benefit essentially accumulates as a deferred tax liability on the issuer’s balance sheet. The primary benefit for the issuer lies in the present value or timing impact of the tax shield cash flows. Assuming the convertible remains outstanding and principal is repaid at maturity, the issuer receives a higher tax shield during the life of the security, but reverses it only at maturity. It is this present value effect of the incremental tax shield that creates enormous value for the issuer.
Based on Lehman’s understanding, the following are the guidelines that determine the conditions in which a tax shield recapture would occur when a CoPa convertible is called:
Scenario 1:
If parity is greater than the tax accreted price of the CoPa convertible (as of the effective date of the call), the issuer does not incur any recapture. In this situation, convertible holders convert their security into common stock.
Scenario 2:
If parity is greater than the call price, but less than the tax-accreted price of the CoPa convertible, the recapture amount equals the tax shield on the difference between the tax-accreted price of the convertible and parity. In this case, also, convertible holders convert the security to the underlying common stock.
Scenario 3:
If parity is less than the call price and the tax-accreted price of the convertible, the recapture amount is the tax shield on the difference between the tax- accreted price of the convertible and the call price. In this case, investors would find it economical to take the call price rather than converting.
Based on the preceding scenarios, it is clear that the issuer of a CoPa convertible is likely to incur the highest recapture costs in scenario 3, followed by scenario 2, and no zero recapture costs in scenario 1. The magnitude of the recapture will depend on 1) the size of the security, and 2) the size of the tax shield benefits that the issuer has reaped. The size of the tax shield benefits are, in turn, a function of, 1) the spread between the YTM of the convertible and the comparable rate used with the CPDI classification of the security, 2) the corporate tax rate of the issuer, and 3) the convertible’s structure (i.e., zero coupon versus cash pay versus par zero bond).
The greater the spread between the convert’s yield and the comparable rate used for tax purposes, the larger will be the tax shield benefit to the issuer.
- All else being equal, zero coupon structures provide higher tax shield benefits relative to cash-pay bond structures.
- The higher the corporate tax rate, the greater will be the value of the tax shield.
Where to find information
In older coverts, look at Paragraph 1 in the Annex under Interest. For example in LIFE 1.5% converts,
In addition, the Company shall pay contingent interest (“Contingent Interest”) to the Holders during any six-month period (a “Contingent Interest Period”) from February 15 to August 14 and from August 15 to February 14, commencing with the six-month period beginning February 15, 2012, if the average Market Price of a Note for the five Trading Day period ending on the third Trading Day immediately preceding the relevant Contingent Interest Period equals $1,200 (120% of the principal amount of a Note) or more per $1,000 principal amount of the Note.
Regarding tax treatment, look under Article 12 Tax Treatment under comparable yield and projected payment schedule
(1) for United States federal income tax purposes, the Company shall accrue interest with respect to outstanding Securities as original issue discount according to the “non-contingent bond method,” as set forth in Treasury Regulation section 1.1275-4(b) using a comparable yield of 6.375%, compounded semiannually and the projected payment schedule attached as Annex 1 to Indenture;
Will the issuer call these bonds or put sweetener
Some issuers do not want to repay the tax recapture so they will give a put sweetener to keep the bonds outstanding. One issuer that is known for put sweeteners is OMC, which uses this strategy to manage converts so that is essentially pays a short term interest rate on a long term instrument.
According to OMC’s treasurer, there is a limitation on the number of times that put sweeteners can be used.
The Copa recapture also discourages the issuer from calling the bond unless the stock is above a certain price so that there is no recapture. To find this out, you must construct a spreadsheet that determines how much the issuer has already benefited from deducting higher taxes. The longer the convert has stayed outstanding, the higher the threshold price to avoid recapture.
American Recovery and Reinvestment Act of 2009
The following is taken from BAC’s report titled, “Tax benefits inspires convertible exchanges” on 10/29/09.
This act provides benefits for applicable convertible bond exchanges and we see recent transactions from WCC, AMMD and BGC partially driven by such tax benefits. By exchanging a newly issued Contingent Payment (CoPa) convertible bond for their existing convertibles, these companies would generate a gain from debt retirement, which can be excluded from taxable income for 5 years and then be amortized over the following 5-taxable-year period. In addition, these companies are allowed to deduct the interest cost on the newly issued converts at a so-called Comparable Yield, which is much higher than the nominal coupon carried on these convertibles.