Moodys 66988
Moodys 66988
Contact Phone
Summary Opinion
The dollar volume of outstanding convertible debt securities has grown more than 50% per year
over the past five years, driven in part by issuers in search of cheap debt financing and in part by
investors in search of the upside potential of a stock with the security of a bond. But, from Moody’s
perspective of credit analysis, convertibles (which allow holders of interest-bearing fixed-income
securities to swap these obligations for common stock when the company’s stock price hits a pre-
determined level) fall short of providing the same protections commonly afforded bondholders.
Generally, convertibles are issued in the form of junior subordinated debt or trust preferred
financings, which places them low in the priority of payment. They are also generally issued by
the holding company, rendering them structurally subordinated to all forms of indebtedness, as
well as other obligations of the operating company, which often increase over time.
Furthermore, the indentures covering convertibles often contain few of the covenants that
afford protection to traditional bondholders, especially in the below-investment-grade cate-
gories. For these reasons, Moody’s ratings reflect the contractual and/or structural subordina-
tion often associated with these securities.
Investors should also be aware of several recent shifts in the composition of the convertible
market and of patterns in its performance that could conspire to increase risk going forward. The
rating composition of issues that have come to market since 1995 has favored those at the lower
ends of both the investment-grade and the high-yield categories. While issuance at all rating levels
has increased, disproportionate growth at the Baa and Caa and lower categories has increased these
credits’ representation as a percentage of the whole. Concentration in new issuance has also
appeared by sector, with High Technology & Electronics, Telecommunications, and Media
together accounting for more than half of outstanding convertibles. Such concentrations raise the
risk that a particular industry may be out of favor just at the time that companies within that sector
most desperately need to tap the market for growth capital or to refinance outstanding securities.
Refinancing risk is also exacerbated by a ramp-up in maturities over the next few years. In
2002, in particular, convertibles account for 25% of all below-investment-grade debt coming
Special Comment
due. Importantly, our default data suggests that the risk of default is greatest not at the time
these securities become due, but rather 24-36 months prior to maturity, which indicates that we
are already in a critical period.
Finally, a look at rating trends among convertible securities from 1995-2000 shows that for the
issues that were outstanding at the beginning of the period, upgrades were more common than
downgrades in 1996 and 1997, but this trend reversed in 1998 and subsequent years. A similar neg-
ative drift in ratings can be observed in later years for other classes as well, indicating that convert-
ible securities that do not see early forced conversion can become increasingly risky with time.
Our data acknowledge the upside of converts. Notwithstanding the narrow six year period
studied, and the prevalence of several years of hard call protection in these issues, about 9% in
dollar amount and 17% in number of issues rated during 1995 through 2000 converted into equi-
ty (in whole or in part) during that same time. Most of the conversions occurred in 1998 and
1999 for convertibles issued in 1995 and 1996. This performance, however, may not be replicated
in a period of falling or less volatile stock prices, when convertibles may not behave as envisioned.
continued on page 3
Selected Moody’s Publications On Value Investing
From Zero to Cash-Pay: Five Years Goes Quickly, February 2001
Leveraged Finance Default Recap & 2000 Outlook: Risk of Loss Near High Water Mark,
March 2000
These Leveraged finance tools are intended to help total return investors monitor both credit and liquidity case by case. By
publishing such studies on an on-going basis, Moody’s hopes to provide a more transparent analytical framework that facilitates
investor vigilance.
© Copyright 2001 by Moody’s Investors Service, Inc., 99 Church Street, New York, New York 10007. All rights reserved. ALL INFORMATION CONTAINED HEREIN IS
COPYRIGHTED IN THE NAME OF MOODY’S INVESTORS SERVICE, INC. (“MOODY’S”), AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE
REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR
ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR
WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of
human or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes no
representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information.
Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to,
any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in
connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct,
indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the
possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, if any, constituting part of the information contained
herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO
WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF
ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other
opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must
accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may
consider purchasing, holding or selling. Pursuant to Section 17(b) of the Securities Act of 1933, MOODY’S hereby discloses that most issuers of debt securities (including
corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to
MOODY’S for appraisal and rating services rendered by it fees ranging from $1,000 to $1,500,000. PRINTED IN U.S.A.
1 This report focuses on convertible debt securities and does not examine convertible preferred stock or convertible exchangeable
preferred stock.
A and above Baa Ba B Caa and below Unrated ◆ % Rated ● HY Portion of Rated
2 Rated dollar volume and issues at year-end include both newly rated issues as well as migration of ratings issued since 1995.
• Low priority of payment: From a structural standpoint, convertibles are low in priority and are
generally issued in the form of junior subordinated debt or trust preferred financings.
• Structural subordination, which often increases over time: Convertibles are often issued by a
holding company (HoldCo), and the proceeds from their issuance are often downstreamed as equity
to an operating company (OpCo). The OpCo is then able to leverage the downstreamed equity by
issuing a combination of bank debt and public notes. Thus the convertibles serve as a platform for
leveraging at the operating company, which in turns causes the convertibles to become increasingly
structurally subordinated over time. This is a form of “double leverage” because the equity at the
OpCo is really debt. Holders of convertibles at HoldCo also face the risk that additional debt will be
“sandwiched-in” at the OpCo, again increasing structural subordination. This embedded risk is pos-
sible because most credit facility agreements and indentures allow for debt issuance senior to con-
verts. OpCo debt typically has a higher structural priority because most of the operating assets and
revenue generation are at the operating company level, the convertibles generally do not benefit
from upstream guarantees, and OpCo debt may be secured by the assets of the operating company.
• Lack of covenant protection: The indentures covering the convertibles typically contain no, or
virtually no, covenants that would restrict or limit the ability of subsidiary operating companies to
incur debt. HoldCo creditors can not depend on covenants at OpCo to protect them, and, generally
speaking, restrictive covenants contained in the credit agreements and indentures at the operating
company can be modified without the consent of HoldCo convertible holders.
• No seat at the bargaining table: Absent upstream guarantees and/or meaningful covenants (which
is most of the time), convertible holders have no seat at the negotiating table and virtually no say in
restructuring at OpCo.
3 For more information on Moody’s notching guidelines, see Moody’s Special Comment, Notching for Differences in Priority of Claims
and Integration of the Preferred Stock Rating Scale, November 2000.
Additional Equity
$300M Conv Common Shares Contribution
$300M
Preferred
Figure 3: Trade Payables And Other Obligations Can Add New Layers Of Subordination
4 For more information, see Moody’s Special Comment, Indenture Covenants are Important - but Protective Attributes are Eroding in
this Late Stage of the Credit Cycle, June 1998.
Limitation on layering
$8.1
large $14.3 billion, or 35%, coming due in 8.0 ✦ 15%
12% ✦ $6.1 $6.4 14%
the six months from July-December 2003, 6.0
10%
as shown in Figure 5. The convertible $3.6
4.0
portion of these maturities, totaling $7.2 $2.3
$1.6 $1.6 $2.0 5%
2.0 $1.5
billion (or 17.6% of all high-yield debt $0.5
through 2003) steps up materially in the 0 ✦ 0%
Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03
first six months of 2002 and ranges
between $1.5 billion and $2 billion for Rated High-Yield Converts
each six-month interval thereafter. Note Total High-Yield Rated Bonds
that convertibles comprise 25% of all ✦ Converts as % of Total High-Yield Bond Maturities
2002 high yield debt maturities. Data in
terms of number of issues does not mate-
rially differ from dollar amount data.5
By rating category, in terms of the dollar amount of high yield maturities, Figure 6 shows that the
majority of high yield convertibles maturing in the 2001-2003 period is in the Ba category.
Generally speaking, the risk of default is typically
higher in the 24-36 months prior to the maturity
Figure 6: Maturing High Yield of a convertible security than on the actual maturi-
Convertible Bonds By Rating ty date itself. The reason that the refinancing risk
becomes more pronounced during that timeframe
4,000 is that the more senior creditors of the company
3,500 often schedule their debt to become due ahead of
3,000 $1,273
the junior debt securities. Thus, if a company’s
prospects are poor, it is likely that the senior credi-
2,500
$1,558 tors, e.g. the banks, are keeping the company’s
2,000
$115 $1,613
credit available on a limited, highly conditioned
1,500
$235
and secured basis. Senior creditors will likely
$891
1,000 exploit their position by reducing exposure and by
$100
500 taking additional collateral. Meanwhile, the con-
$714
0
$667
vertibles can be left meaningfully “out of the
2001 2002 2003 money” or even “busted”. Covenants contained in
the credit agreements can play a very important
Ba B Caa role in these instances and can give bank lenders
the advantage over lesser priority creditors, which,
in turn, have few protective covenants.
5 For more information, see Moody’s Special Comment, Refunding Risk for Speculative Grade Borrowers, 2001-2003,
December 2000.
Sector concentrations also pose a risk because one industry may be out of favor at exactly the time
when it needs to raise new growth capital or refinance.7 Looking at sector concentration among convert-
ible securities issuers (see Figure 8 below), we see that an important shift has occurred in tandem with the
last five years of 52% CAGR of rated dollar volume of outstanding convertibles. Three industries current-
ly represent 54% of the rated market, with the rest of the market highly fragmented by sector.
Figure 8: Three Sectors Comprise More Than Half The Rated Convertible Market
1995 2000
Rated Market Size: $15.6 billion Rated Market Size: $127.4 billion — CAGR: 52%
All Other
(45%; $7.0B)
Media Media
(23%; $3.5B) (16%; $20.4B
CAGR: 42%)
The fastest growing sector in terms of issuance has been Telecommunications — increasing from 4%
of the total in 1995 to 11% in 2000 — a compounded growth rate of 83%. The second fastest growing
sector has been High Technology & Electronics — increasing from 22% of the total in 1995 to 27% — a
compounded growth rate of 59%. The third fastest growing sector has been Media — but it grew at a
CAGR of only 42% — less than the market as a whole — and consequently its share of the rated market
decreased from 23% in 1995 to only 16% in 2000.
6 For convertibles issued between 1995 and 2000.
7 Moody’s Special Comment on refinancing risk in the telecommunications sector addresses this point in great detail. See From Zero
to Cash-Pay: Five Years Goes Quickly. What will The Market Be Like in 2003? February 2001.
40%
◆
◆
■
20% ■ ✚ ●
■
▲
0%
■ ■
■ ▲
-20% ✚
■
◆ ■
-40% ◆
■
▲
-60%
-80%
◆
-100%
We then aggregated the “first-year drifts”; the “second-year drifts”, the “third-year drifts”, and so on,
for the various classes 1995 - 2000 in order to look at the various classes by stage of maturity (see Figure
11 on next page).
Although upgrades outpaced downgrades by over 2-to-1 in the first year after issuance, by the fifth
year, downgrades were greater than upgrades by about 6-to-1. Moody’s recognizes the thinness of the
data in the later years, particularly the fifth year, because the class of 1995 was the only class to experience
a fifth year, and because one issuer that year had a disproportionately negative ratings drift.9 Nonetheless,
of the remaining issues in year five, there was a net of 11 downgrades (2 upgrades less 13 downgrades),
supporting the argument that the longer the issues are outstanding, the riskier they can become.
9 Due to forced conversions, prepayments and defaults, the number of rated issues for the class of 1995 fell from 47 in 1995 to only
12 in 2000. One particular issuer, Laidlaw One, Inc., was downgraded 10 notches during that year.
Further indicating increased risk as a convertible security matures is the fact that the universe of cor-
porate debt did not experience a similar trend in ratings drift over the same period. Figure 12 shows the
results by stage of maturity of using the identical methodology as described above to analyze U.S. corpo-
rate debt (bank loans, regular public debt and convertible debt of non-financial corporate issuers). Over
the same 1995-2000 time period, Moody’s observed that ratings for all debt “drifted” down in the first
year after issuance, and then after briefly accelerating downward, began to moderate in later stages of
maturity. On the other hand, the negative ratings drift for convertible debt alone accelerated in each addi-
tional maturity stage.
10 Includes bonds, bank loans and convertibles for USD issues of U.S. domiciled non-financial corporate issuers
11 For more information on liquidity risk, see Moody’s Special Comments Alternate Liquidity: Current Topics and Trends, November
1999 and Rating Methodology: Assessing the Strength of a Liquidity Facility, June 1999.
$120 $160
▲ ▲
■
▲
■
▲ $140
▲ ▲
$100 ▲
■ ▲ ▲
■ ■
■
■ ▲ ▲ $120
■ ▲ ▲ ■ ▲ ▲
▲ ▲
$80 ■ ▲▲ ▲ ▲ ▲ ■
▲▲ ■ ▲ ■ ▲
▲ ▲ ■ ■ ▲ ■ ▲ ▲
▲ ▲▲
▲▲ ▲▲ ▲▲
■ ▲■
▲▲
▲ ▲ ▲ ▲▲
■ $100
■ ▲ ■
■ ■
▲ ■ ■ ▲▲ ■ ■
■ ■■ ▲
▲▲■ ■ ■ ▲▲
■ ▲ ▲ ■ ■
■ ■ ■ ■ ■ ■
■ ■ ▲ ▲▲
■ ■ ■ ▲ ▲ ■ ■■ ▲▲
$60 ■■ ■
■ ▲ ■ ■ ■ $80
■■ ■ ■ ▲ ▲
■■
■■ ▲ ■ ■ ▲▲ ▲▲▲▲
■ ■ ▲▲ ▲ ▲
■ ■ ■ ■ ▲▲ ▲
■ ▲ ■ ▲▲
■■■■ ▲ ▲ ▲ $60
■▲ ▲
$40 ■■ ■ ▲ ■ ▲
■ ■ ■■ ■ ▲ ▲
■ ▲
■■ ■
■ ■ ■ ■ ■ ■ ▲▲ $40
■ ■
■■
■
■■■
$20
■■ $20
$0 $0
160% 100%
▼▼ 90%
140% ●
●
80%
● ●
120% ● ●
●
● ● 70%
100% ● ● ● ●
● ● ●
●
● ▼ 60%
● ●● ●
● ●
●● ● ● ● ● ●● ▼
● ● ● ● ● ● ● ● ▼ ▼
80% ● ●● ● ●● ● 50%
●● ● ● ●
● ● ▼ ▼▼
●●●● ● ●
● ●
▼
●● ▼▼
● ● ▼ 40%
▼ ▼
60% ●
● ● ● ▼
▼ ▼● ▼ ●●
▼ ▼
▼ ▼ ▼ ●
▼▼ ▼
●
▼ ●●▼ ▼
●▼ ▼● ●
●●▼ ● 30%
▼ ▼▼▼ ▼▼ ▼ ● ●●
40% ▼ ▼▼ ▼ ● ● ● ●
▼ ▼ ▼ ▼▼▼ ▼▼▼ ▼ ▼ ▼ ● ●●
▼▼ ▼ ▼▼ ▼▼ ▼
▼ ▼ ▼▼ ▼ ▼▼ ▼ ▼
▼ ●●● 20%
▼ ▼ ▼▼▼ ▼▼ ▼ ▼▼ ▼▼
▼ ▼ ▼ ▼▼▼
20% ▼▼ ▼ ●●
▼ ▼ ▼
10%
0% 0%
● Parity ▼ Premium
$35
$30
$25
Price Per Share
$20
$15
$10
$0
Oct-98
Oct-99
Oct-00
Nov-97
Dec-97
Jan-98
Feb-98
Mar-98
Apr-98
May-98
Jun-98
Jul-98
Aug-98
Sep-98
Nov-98
Dec-98
Jan-99
Feb-99
Mar-99
Apr-99
May-99
Jun-99
Jul-99
Aug-99
Sep-99
Nov-99
Dec-99
Jan-00
Feb-00
Mar-00
Apr-00
May-00
Jun-00
Jul-00
Aug-00
Sep-00
Nov-00
Dec-00
Jan-01
AMF’s Rolling 12 Months ROA and Capital Spending
7.00% $350
5.91%
6.00% $300
$304 $240
5.00% $250
-2.00% -$100
Dec-96
Feb-97
Apr-97
Jun-97
Aug-97
Oct-97
Dec-97
Feb-98
Apr-98
Jun-98
Aug-98
Oct-98
Dec-98
Feb-99
Apr-99
Jun-99
Aug-99
Oct-99
Dec-99
Feb-00
Apr-00
Jun-00
To order reprints of this report (100 copies minimum), please call 800.811.6980 toll free in the USA.
Outside the US, please call 1.212.553.1658.
Report Number: 66988