Don’t look back in anger

Cash-out options are now almost universally included in exchangeable bonds and are fast becoming common, even in convertible bonds. But investors should be wary of this feature. While it benefits issuers, it can take value away from the investor. A cash-out option gives issuers the ability to deliver the cash value of the underlying securities on conversion, thereby greatly enhancing flexibility from their perspective. But this can often work against investors. With an exchangeable, this means that the issuer need not physically hold the shares for delivery, but can hedge out their exposure with derivative transactions or, indeed, if the shareholding has increased in importance, the issuer need not deliver shares that they wish to retain. For convertible issuers, the cash-out option allows the company to prevent equity from being issued if the firm is overcapitalised. From the investor’s perspective, the existence of a cash-out option does not in itself affect the valuation. What does make a difference is how the cash value of the underlying securities is calculated and specifically whether there is a “look-back” option for the issuer. The cash value of the underlying securities will be determined over an averaging period. If the issuer knows the value from this averaging period (ie, if they can “look back”) before they decide whether to give the investor cash or shares, they have the opportunity to deliver whichever has the lowest value. This optionality for the issuer clearly takes value away from the investor. Look-back options are very common in US issues and, indeed, investors should expect US issuers to extract the maximum value from these clauses. In Europe, cash-out options are seen as creating flexibility for issuers rather than necessarily creating value and even where the issuer has a look-back option, many will tell investors of their intentions in advance. Indeed, later issues in Europe have removed the look-back from cash-out options, requiring issuers to inform investors of their intentions regarding the cash-out option in advance. It is also possible that an issuer can actually give a look-back option to the investor. This happens when the issuer is obliged to inform the investor in advance of whether they intend to give cash or shares and where the averaging period is prior to the conversion date. This can effectively give a look-back “put” option to investors if the company chooses to deliver cash.

Extracts from US Cellular 0%

2015 USD bond prospectus: “In lieu of the delivery of Common Shares upon notice of conversion of any LYON, the company may elect to pay the Holder surrendering a LYON an amount in cash equal to the Sale Price of a Common Share on the Trading Day immediately prior to the Conversion Date multiplied by the Conversion Rate… …the Company shall inform the Holder through the Conversion Agent, no later than two business days following the Conversion Date, (I) of its election of the delivery of Common Shares or to pay cash in lieu of delivery of such shares… ...If the Company elects the delivery of Common Shares, such shares will be delivered through the Conversion Agent as soon as practicable following the conversion date. If the Company elects to pay cash, such cash payment will be made to the Holder surrendering such LYON no later than the fifth business day following such Conversion Date. …The “Sale Price” on any Trading Day means the closing sale price per share for the Common Shares…”

CONTACT: Michael O’Connor

Co-Head of Convertible Research

Deutsche Bank AG London

Global Equities

1 Great Winchester Street

London EC2N 2EQ

England, UK

Tel: +44 (0) 20 7545 2361

Fax: +44 (0) 20 7545 2013