Europeans must study innovations

The global convertibles market has grown at an extraordinary pace: last year there was $160bn of issuance. More than anything, this has been driven by structural innovations and last year the so-called contingency revolution powered the growth of the US convertible market. But what are the implications of the Contingent Payment (CoPay) and Contingent Conversion (CoCo) structures for European investors? CoPay convertibles CoPay bonds contain features that draw them under the US Inland Revenue Service’s Contingent Payment Debt Instrument (CPDI) regulations. This allows the issuer to claim annual deductions against income tax based on their normalised non-convertible cost of debt. These bonds tend to be zero-coupon instruments, a situation which is extremely beneficial for the issuer; the company will receive a substantial tax shield, despite no annual interest payments. And, if the convertible ends up in profit, the company can use the investor’s capital gain to reduce its tax bill. Onshore US investors have to pay tax on the “phantom income” as if they had received an interest coupon equal to the company’s normalised non-convertible cost of debt. On conversion, any capital gain above this normalised return will also be treated and taxed as income. This is a dreadful tax situation and the CoPay structure has largely been sold offshore. European investors should not fall under US taxation and should not be penalised by this structure. European companies can benefit by issuing bonds out of US tax-paying subsidiaries. Roche’s main US subsidiary issued the first CoPay convertible from a European company in July last year. Given the tax benefits of the structure, further European companies can be expected to follow Roche’s lead. CoCo bonds CoCo features are an accounting innovation developed to minimise the dilutive impact of convertibles under US generally accepted accounting principles (GAAP). Basically, conversion is only possible if the shares trade above a specified trigger, commonly 110 or 120 per cent of the conversion price. While the shares trade below this trigger, the bond is not convertible and the company does not need to account for any dilution. Investors are protected against corporate actions, with the restriction on conversion lifted most notably under merger and acquisition scenarios, if a special dividend is paid or if the bond is called for early redemption. But this structure has negative valuation implications for investors. The graph below shows the impact of the CoCo feature as maturity approaches. CoCo bonds’ greatest risk to investors concerns their treatment by prime brokers. If the bonds are non-convertible, an arbitrageur’s long-bond is not “fungible” against their short-stock position. Prime brokers do not take this into account when calculating margin requirements from, and leverage available to, convertible arbitrage investors who run CoCo positions. If this were to happen, the basis of these bonds would fall, affecting all investors. Although CoCo bonds take optionality and value away from investors, the accounting benefits to issuers mean that this feature is likely to remain commonplace. Any European companies which use US GAAP can already issue CoCo bonds but preliminary inquiries suggest that other accounting regimes may give similar treatment. Michael O’Connor is head of international convertible research at Deutsche Bank.