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Moodys 66988

convertible

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July 2001 Special Comment

Contact Phone

Of Convertible Debt Securities


Critical Issues in Evaluating the Creditworthiness
New York
Pamela M. Stumpp 1.212.553.1653
Kevin Ziets
Tom Marshella
Michael Rowan

Critical Issues in Evaluating the Creditworthiness


Of Convertible Debt Securities

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

Refunding Risk for Speculative Grade Borrowers, 2001-2003, December 2000

Bank Loan Loss Given Default, November 2000

Moody’s Approach to Evaluating Distressed Exchanges, July 2000

Putting EBITDA in Perspective: Ten Critical Failings of EBITDA as the Principal


Determinant of Cash Flow, June 2000

Leveraged Finance Default Recap & 2000 Outlook: Risk of Loss Near High Water Mark,
March 2000

Moody’s Default Report, available monthly at www.MoodysRMS.com

Alternate Liquidity: Current Topics and Trends, November 1999

Credit Considerations in Assigning a Caa1, June 1999

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.

Author Associate Analyst Editor Contributors Production Associates


Pamela M. Stumpp Kevin Ziets Crystal Carrafiello Richard Lane Alba Ruiz
Marie Menendez Philip Stone
William Lee Cassina Brooks
Daniel Marx
Rob McCreary

© 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.

2 Moody’s Special Comment


Introduction
On February 1, 2001, The Wall Street Journal published an article on convertible bonds, Burning Issues:
Convertible Securities Are This Year’s Big Model, which stated the following:
In the aftermath of last year’s stock-market slide, convertibles remained one of the healthiest prod-
ucts for Wall Street firms. That is because these hybrid securities offer the safety of a bond, with
features like annual interest payments, with the upside potential of a stock, since the investor is able
to swap his securities for common stock at a predetermined premium to current market prices,
providing exposure to any rise in stock prices.
This report outlines the key credit issues that we consider in rating convertible securities and in the
process explores the degree to which convertibles do or do not offer the “safety of a bond.” It begins by
examining the tremendous growth in issuance of these securities over the past five years and highlighting
identifiable trends in such issuance by rating category. It then explores each of the key factors that influ-
ence Moody’s ratings of these securities, including priority of payment, structural subordination, covenant
protections, liquidity, and refinancing risk. It also explores rating drift - net upward or downward move-
ments in ratings — for the asset class as a whole to determine the manner in which the risks associated
with these investments change over time. It ends with three case studies of well known names: Xerox,
Amazon.com, and AMF Bowling, which highlight the way in which these issues have played out in the rat-
ings and performance histories of individual credits.

Convertible Issuance Booming; Baa And Caa See Greatest Growth


Over the past five years, the dollar volume of outstanding convertible securities has grown at a rapid pace,
while the composition of this universe has shifted in favor of issues at the bottom rungs of both invest-
ment-grade and speculative-grade.1
Based on dollar volume, the total market has grown at a 53.9% cumulative annual growth rate
(CAGR) to $159 billion in 2000. Of this $159 billion, approximately 80%, or $127.4 billion is currently
rated by Moody’s, and of the $127.4 billion rated, just more than half (52.7% or $67.2 billion) is invest-
ment-grade, and slightly less than half (47.3% or $60.2 billion) is speculative-grade. (See Figure 1.)

GROWTH BY DOLLAR VOLUME OF RATED AND UNRATED CONVERTIBLES


Figure 1 also demonstrates that the high-yield portion of the rated universe has decreased from 65.4% in
1995 to 47.3% at the end of 2000 on a dollar volume basis. But these figures, in and of themselves, are not
accurate reflections of risk concentration. Note that the credit composition of rated convertibles during
this period has changed dramatically, with the greatest growth in the Baa (the lowest rating category in
investment-grade) and in Caa and below (the lowest categories in high-yield). The Baa category has
grown at an 83.8% CAGR (from a base of $2.4 billion in 1995 to $50.9 billion in 2000), while the Caa and
below categories have grown at a 119.9% CAGR (from a base of $297 million in 1995 to $15.3 billion in
2000). By comparison, the A and Ba categories have grown at a slower pace and have consequently
declined as a percentage of the total.
On a combined basis, the Baa and Caa and below categories grew from 17.5% to 52% of the total
rated dollar volume of convertibles from 1995 to 2000. The strong relative growth in these two rating cat-
egories has, in part, been driven by two types of issuers:
1. Those with Baa rated convertibles, whose stock may be at the upper-end of the 52-week range, thus pos-
ing unlikely near-term conversion. Convertible securities are a cheap source of debt for these issuers.
2. Those with Caa and/or below rated convertibles, whose equity bases are modest, and whose business
plans call for debt-financed growth. These issuers may have no option other than to issue debt junior to
bank debt. They choose convertibles over other kinds of debt because of their limited ability to attract
equity together with the desire of investors to get a fixed return with equity upside. In these risky situa-
tions, converts often serve as the junior debt, enabling a company to attract more senior debt.

1 This report focuses on convertible debt securities and does not examine convertible preferred stock or convertible exchangeable
preferred stock.

Moody’s Special Comment 3


GROWTH BY NUMBER OF ISSUES OF RATED AND UNRATED CONVERTIBLES
The second chart in Figure 1 also shows the growth of the convertible securities market, but this time in
terms of the number of issues. The number of rated deals grew at a 30.5% CAGR over the 5-year period
from 1995-2000, which is lower than the growth rate in dollar volume and is consistent with the fact that
the average rated deal size has more than doubled to $392 million.
On a per-issue basis, the percentage of the total universe that is rated remains virtually unchanged at
61%, which is lower than the 80% coverage by dollar amount because a significant number of smaller
weaker issues are unrated.
The high-yield component of the rated market has moderated a bit from 68.6% to 64.9% (consistent
with the drop in the high-yield component for dollar volume). Again, the fastest growth came from both
the Baa (CAGR 49.1%) and the Caa and below (CAGR 52.8%) categories, although it should be noted
that their growth came off of very low initial levels.

Figure 1: Market Growth Greatest at Baa and Caa Levels2

Rated Converts 1995-2000 ($'s in billions)


180.0 100%
5-Year CAGR 1995 2000
160.0 84.7% 90%
80.1% 79.6%
◆ 76.1% 78.1%
140.0 ◆ ◆ ◆ ◆ ◆80% A and above 40.6% 16.1% 10.2%
65.4% 70% Baa 83.8% 13.2% 35.6%
120.0 ● 60.8% 56.9% Ba 25.4% 37.3% 22.8%
54.3% 56.3%
● ● 60%
100.0 ● ● B 50.8% 16.5% 33.2%
80.0 ●50% Caa and below 119.9% 1.6% 31.9%
40% High-Yield only 42.7% 55.4% 37.9%
60.0 Investment Grade 65.6% 29.3% 42.3%
30%
40.0 Total Rated 52.2% 84.7% 80.3%
20%
Unrated 62.0% 15.3% 19.7%
20.0 10% Total Market 53.9% 100.0% 100.0%
0.0 0%
1995 1996 1997 1998 1999 2000

Rated Converts 1995-2000 (number of issues)


550 100%
500 5-Year CAGR 1995 2000
69.9% 90%
450 71.2% 80% A and above 15.6% 11.4% 6.2%
69.3%
400 68.6% ◆ 54.8%
◆ ◆ ◆ ◆ 70% Baa 49.1% 7.9% 16.3%
350● ● ◆
●60% Ba 20.6% 14.3% 12.2%
● 68.3% ●
300 61.4%
57.0%
● 59.5% 61.9% B 27.2% 23.6% 30.0%
50% Caa and below 52.8% 4.3% 19.5%
250
200 40% High-Yield only 29.0% 42.1% 39.8%
150 30% Investment Grade 33.4% 19.3% 21.5%
20% Total Rated 30.5% 61.4% 61.3%
100
Unrated 30.6% 38.6% 38.7%
50 10%
Total Market 30.5% 100.0% 100.0%
0 0%
1995 1996 1997 1998 1999 2000

A and above Baa Ba B Caa and below Unrated ◆ % Rated ● HY Portion of Rated

Structural Elements Create Important Differences Between Convertibles And Bonds


The tremendous growth and popularity of convertibles, especially among issuers at the lower ends of both
the investment-grade and speculative-grade categories, raise some concern as to the security of these
investments relative to other debt instruments. In contrast to the popular argument that convertibles offer
the safety of a bond, from Moody’s standpoint of credit analysis, key bondholder safety elements are often

2 Rated dollar volume and issues at year-end include both newly rated issues as well as migration of ratings issued since 1995.

4 Moody’s Special Comment


absent in the structuring of convertibles and the economic substance of convertibles is often more akin to
equity than to debt. Therefore, Moody’s ratings reflect the contractual and structural subordination often
associated with these securities. Assuming a simple (one-company) legal organizational structure, convert-
ible subordinated debt will likely be rated at least one-notch lower than the senior implied or senior unse-
cured rating for companies whose senior implied rating is Ba2 and above, and at least two-notches below
the senior implied rating for companies whose senior implied rating is Ba3 and below.3
Among the factors that lead to this credit assessment are:

• 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.

Moody’s Special Comment 5


Subordination Begins Deep And Could Go Deeper
United Rentals serves as a good example of these structural elements and especially of how holding com-
pany convertibles can be used as a platform for leveraging the enterprise. In the fall of 1998, United
Rentals formed a new HoldCo (United Rentals Inc.) to issue $300 million of convertible quarterly income
preferred securities (QUIPS). Convertible subordinated notes were issued to a trust that, in turn, issued
the $300 million of QUIPS. The proceeds of the QUIPS were lent back to HoldCo by the trust and then
downstreamed as equity to United Rentals North America, its wholly owned operating subsidiary. The
proceeds were used by the OpCo to repay bank debt and to restore availability under its credit facilities for
future borrowings.
In this case, structural subordination increased over time as OpCo incurred a significant amount
of additional indebtedness subsequent to HoldCo’s $300 million QUIPS issuance in August 1998.
The company has intentionally maintained a stable level of debt/book capitalization, aided by the
issuance of $450 million of perpetual cumulative preferred stock at HoldCo. However, while HoldCo
debt has remained the same, the absolute amount of OpCo debt has increased by $1.5 billion (from
$1.2 billion 9/98 to $2.7 billion 12/00). The QUIPS are not only structurally subordinated to a high-
er amount of debt at OpCo, but the increase in OpCo debt has failed to produce greater market
value. In fact, from 9/98 to 12/00 the market value of the common equity declined by 41.6% (from
$1.6 billion to $955 million). Since year-end there have been increases in both debt and market equi-
ty, which tend to offset each other.
Moody’s ratings reflect the structural subordination of the $300 million of QUIPS to debt at OpCo.
The rating for the $300 million QUIPS is B3, while the rating for OpCo senior subordinated notes is B2.

Figure 2: Convertible Securities Of Holding Company


Can Be Deeply Subordinated To Operating Company Obligations

$300M 6 1/2% Conv Sub


Debentures
United Rentals,
United Rentals
Inc.
Trust $300M loan
(Holding Co.)
Subordinated Guarantee

Additional Equity
$300M Conv Common Shares Contribution
$300M
Preferred

Investors United Rentals


(North America),
$2.8 Billion Debt
Inc.
(Operating Co.)

6 Moody’s Special Comment


In addition to the structural subordination that may occur through funded subsidiary indebtedness,
industry attributes may also magnify the effect of structural subordination. A good example is Owens &
Minor, Inc., which is the nation’s second-largest distributor of medical and surgical supplies. The compa-
ny conducts business through its direct subsidiaries, Owens & Minor Medical, Inc. and Stuart, and its
indirect subsidiaries. Owens & Minor, Inc. (HoldCo) has no operations of its own and is dependent on the
cash flow from its subsidiaries in order to meet its debt service obligations, including its obligations under
the junior convertible subordinated notes.
In examining the depth of the subordination, it is important to consider all senior and subordinated
debt of the holding company. This includes HoldCo’s obligations under its $225 million revolving credit
facility ($2 million at December 2000) and its $150 million of senior subordinated notes. It is also impor-
tant to consider other obligations of the HoldCo’s subsidiaries because the junior convertible subordinat-
ed notes are not guaranteed and are structurally subordinated to all obligations of the company’s sub-
sidiaries, including trade payables. Trade payables are sizable for distributors, in general, and totaled $292
million at December 2000 for the company’s operating subsidiaries.
Moody’s assigned a B2 rating to the $132 million junior subordinated debentures, one-notch below
the B1 rating assigned to the $150 million senior subordinated debentures reflecting the subordination of
the junior subordinated convertibles to the senior subordinated notes. The senior subordinated notes also
benefit from subordinated upstream guarantees of the operating subsidiaries.

Figure 3: Trade Payables And Other Obligations Can Add New Layers Of Subordination

$132M 5.375% Cvt Jr Sub $225M Revolving Credit


debentures, due 4/30/13 Facility, exp. 04/2003
Owens & Minor Owens & Minor ~$7m outstanding 9/00
Trust I Inc.
Guarantee, subordinated
$150M 10.875% Senior Sub
Guarantee notes, due 06/01/2006
$132M 5.375% Cvt
Securities, Series A
Guarantee Subordinated
Mandatorily Redeemable
Preferred, 4/30/13 Guarantee

$225M Receivables Payables


Financing Facility, $316M
due 7/2001 Owens & Minor Operating
$70M outstanding 9/30
Funding Corp Subsidiaries

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.

Moody’s Special Comment 7


Other examples of ways in which industry attributes can magnify the effect of structural subordination
include the structural subordination of HoldCo convertibles to closure and post-closure liabilities, and
remediation obligations of subsidiaries in the waste industry; and to payables, payroll, and related taxes
(including the employer’s share of social security, federal and state unemployment taxes, and workers
compensation insurance) of subsidiaries in the staffing industry; and to both non-cancelable operating
lease obligations and payables of subsidiaries in the retail industry.

Indenture Covenants Notable By Their Absence


While indenture covenants alone are not a sine qua non for a particular rating, an integral part of Moody’s
rating process continues to be a careful analysis of covenants contained in both indentures and how they
might impact the risk profile of a bond. That assessment is incorporated into the credit ratings we issue.4
Indentures for investment-grade securities have traditionally contained few covenants and now typical-
ly contain only weak limitations on liens and sale-and-leaseback transactions. Indentures for high-yield
companies, in contrast, typically contain many covenants, including a limitation on indebtedness, limita-
tion on restricted payments, limitation on the creation of liens, and limitations on the sale of assets.
While covenants for both investment-grade and non-investment-grade companies typically contain
broad carve-outs that can erode their effectiveness, note agreements covering convertibles typically con-
tain no, or virtually no covenants and consequently place no restriction on a holding company’s ability to
leverage its subsidiaries. Moreover, there are no restrictions regarding “restricted” and/or “unrestricted”
subsidiaries; from a convertible security holder’s standpoint, all subsidiaries are effectively unrestricted.
Covenant protection is most needed when a company is in financial distress and the convertibles are
either significantly out of the money or “busted”. This is precisely the time when a company’s more senior
creditors, who enjoy covenant protection, may be exploiting covenants contained in their respective credit
agreements in order to reduce exposure and/or to take collateral.
In an absolute sense, the rights of convertible holders do not change in a distressed situation because
convertibles typically lack meaningful protective covenants from the outset. In a relative sense, however,
the position of convertible holders can weaken compared with those of a company’s senior creditors who
can take action to improve their relative exposure.

Figure 4: Covenant Protections Scarce In Convertible Structures


Investment-Grade Indentures High-Yield Indentures
Convertible Indentures (excluding Convertibles) (excluding Convertibles)
None, or virtually none Weak limitation on liens Limitation on indebtedness

Weak limitation on sale Limitation on restricted payments


and leaseback Transactions

Limitation on sales of assets and subsidiary stock

Provisions regarding mergers and Consolidation

Payment restrictions affecting subsidiaries

Limitation on the creation of liens

Limitation on affiliate transactions

Limitation on layering

Limitation on capital stock of restricted Subsidiaries

Limitation on the sale or issuance of preferred


stock of restricted subsidiaries

Future subsidiary guarantors

Limitation on lines of business

8 Moody’s Special Comment


Convertible holders should not rely on the existence of more restrictive covenants contained in a com-
pany’s credit agreement to compensate for the absence of indenture covenants because such agreements
could be modified in the future. Furthermore, certain covenants, such as a limitation on liens, provided to
a company’s other creditors will not indirectly advantage convertible debt holders whose note indentures
do not contain such provisions.

Ramp-Up In Convertible Maturities, Sector Concentrations Pose Refinancing Risk


Moody’s also takes into account refinanc-
ing risk when assigning a rating to a con-
vertible security - just as we do for any Figure 5: Convertibles Will Reach 25%
other debt security. But unlike other debt Of All 2002 High-Yield Debt Maturities
securities, the refinancing of a convertible
poses some additional concerns because of
its low priority in the capital structure 16.0 30%
26% $14.3
which, as we have seen, can be com- 14.0 ✦
24% ✦ 25%
pounded over time. A total of $40.7 bil-
Face Amount of Maturing Debt
12.0
lion of high-yield debt (excluding bank 19% 20%
10.0 ✦
loans) matures through 2003, with a very
($'s billions)

$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.

Moody’s Special Comment 9


Figure 7 contains a list of rated U.S. corporate convertible bonds issued during 1995 through 2000
that also defaulted during that period.

Figure 7: Convertible Bond Defaults 1995-20006


Issuer Amount Default Date Maturity Coupon Default Rating Issuance date
Boston Chicken, Inc. $720.0 10/5/98 6/1/15 0 Ca 5/24/95
AMF Bowling, Inc. $514.3 8/14/00 5/12/18 0 C 4/29/98
Sun Healthcare Group, Inc. $345.0 4/29/99 5/1/28 7 Ca 4/21/98
Boston Chicken, Inc. $287.5 10/5/98 5/1/04 7.75 Ca 4/23/97
PhyCor, Inc. $200.0 8/15/00 2/15/03 4.5 B1 2/7/96
Fine Host Corporation $175.0 1/7/99 11/1/04 5 Ca 10/22/97
Integrated Health Services, Inc. $143.8 11/1/99 1/1/01 5.75 Ca 2/28/95
Sunterra Corporation $138.0 5/15/00 1/5/07 5.75 C 1/29/97
Physicians Resource Group, Inc. $125.0 12/1/98 12/1/01 6 C 12/6/96
Family Golf Centers, Inc. $115.0 10/15/99 10/15/04 5.75 Ca 10/10/97
Innovative Clinical Solutions, Ltd. $100.0 7/14/00 6/15/03 6.75 C 6/21/96
FPA Medical Management, Inc. $80.7 6/15/98 12/15/01 6.5 Caa2 12/13/96
Geotek Communications, Inc. $75.0 6/29/98 2/15/01 12 Caa2 3/5/96
PHP Healthcare Corp. $69.0 11/19/98 12/15/02 6.5 Ca 12/14/95
Imagyn Medical Technologies, Inc. $50.0 3/31/98 5/30/06 8.75 Ca 5/13/96
Read-Rite Corporation $19.8 3/1/00 9/1/04 6.5 C 7/23/98

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%

High Tech All Other High Tech


/Electronics (41%; $52.2B /Electronics
(22%; $3.4B) CAGR: 49%) (27%; $34.7B
CAGR: 59%)

All Other
(45%; $7.0B)

Media Media
(23%; $3.5B) (16%; $20.4B
CAGR: 42%)

Retail & Consumer Tele- Retail & Consumer Tele-


Products communications Products communications
(6%; $1.0B) (4%; $0.7B) (5%; $6.7B (11%; $13.5B
CAGR: 46%) CAGR: 83%)

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.

10 Moody’s Special Comment


Illustrating the diversity of the “All Other” category is the fact that Retail & Consumer products, the
next largest segment after Telecommunications, represented only 5% of the rated market in 2000. At the
end of 1995, Retail was the third largest convertible bond sector at 6%, but strong relative growth in
Telecommunications and Technology has moved Retail out of the top three and has pushed All Other
from 45% to 41% of the market.

Rating Trends Suggest Risks Of Convertibles May Increase Over Time


In addition to the risks noted above, a look at rating trends among convertible securities from 1995-2000
seems to indicate that convertible securities that do not see early redemption or conversion may face cred-
it deterioration over 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 ($11.0 billion of $121.1 billion) and 17% in number of issues (58 of 331) rated during 1995
to 2000 converted into equity during that same time.8 However, the data indicate that smaller issues have
a higher propensity to be converted, as a higher percentage of issues relative to dollar amount had this
experience during the period. We observed that many of these smaller issues were those of companies that
were acquired during the period. Additionally, the data indicate that the bulk of these conversions
occurred in 1998 and 1999 for convertibles issued in 1995 and 1996. Nonetheless, the future redemption
and conversion performance may not replicate that of the 1995 and 1996 issues, as a period of falling or
less volatile stock prices may cause convertibles not to behave as envisioned.
Our examination begins by establishing a base group of ratings called a cohort. In 1996, the cohort
consists of the total number of issues that existed at year-end 1996 that also existed at year-end 1995. This
serves as the denominator against which net rating activity is examined. There were 47 newly rated issues
in 1995 from which 4 issues were withdrawn, leaving a 1996 cohort of 43.
Net rating activity was calculated by taking the total number of notches upgraded less the total num-
ber of notches downgraded for the cohort. In 1996, we had 14 notches upgraded less 2 notches downgrad-
ed for net upgrades of 12. The 12 net upgrades as a percentage of the 43 cohort produced a positive rat-
ings drift of 27.9% for 1996.
We also calculated the one-year ratings drift for years 1997 through 2000 in the same manner. For
example, the 1997 cohort consisted of issues that existed at year-end 1997 that also existed at year-end
1996 — this includes remaining issues from the 1996 cohort plus new issues rated in 1996 that still existed
at the end of 1997.
The ratings drift is positive for 1996 and 1997, but then turns negative for 1998 through 2000 as
shown in Figure 9.

Figure 9: Convertible Debt One-Year Ratings Drift By Year


40%
30% 27.9%
21.5%
20%
10%
0%
-10%
-8.6% -7.2%
-20%
-30% -22.1%
1996 1997 1998 1999 2000

1996 1997 1998 1999 2000


Sum Notches Up 14 28 43 45 56
Sum Notches Down (2) (8) (55) (58) (103)
Net Upgrades less Downgrades 12 20 -12 -13 -47
Prior Year Issues (Base) 47 103 162 210 239
Withdrawn Issues 4 10 22 29 26
Base less withdrawn 43 93 140 181 213

8 Numbers include both partial and full exchanges.

Moody’s Special Comment 11


While Figure 9 examines one-year ratings drift on a cumulative going forward basis for all issues rated
in 1995 and beyond, Figure 10 segments the drift by year of issuance (i.e. “class”) and follows each sepa-
rate class from year to year. For example, the class of 1995 is the only class in which we have five years of
one-year ratings drift. The class of 1996 has four years of ratings drift; the class of 1997 has three years of
drift, and so on.
Again, with the exception of the initial year, (and the initial two years in the case of the class of 1995),
all subsequent years for each class show a negative ratings drift. This is particularly noteworthy in light of
the fact that 1996, 1997 and 1998 were years in which upgrades significantly exceeded downgrades.

Figure 10: Convertible Debt One-Year Ratings Drift By Year Of Issuance

40%



20% ■ ✚ ●


0%
■ ■
■ ▲
-20% ✚

◆ ■
-40% ◆

-60%

-80%

-100%

◆ Class of 1995 ▲ Class of 1997 ● Class of 1999

■ Class of 1996 ✚ Class of 1998 ■ Entire Cohort

One-Year Ratings Drift


Year of Issuance 1996 1997 1998 1999 2000
1995 1995-1996 1996-1997 1997-1998 1998-1999 1999-2000
1996 NA 1996-1997 1997-1998 1998-1999 1999-2000
1997 NA NA 1997-1998 1998-1999 1999-2000
1998 NA NA NA 1998-1999 1999-2000
1999 NA NA NA NA 1999-2000

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.

12 Moody’s Special Comment


Figure 11: Convertible Debt One-Year Ratings Drift By Stage Of Maturity
40%
16.7%
20%
0%
-20% -6.1%
-40%
-40.7%
-60%
-80% -41.7%
-100% -91.7%
Year1 Year2 Year3 Year4 Year5

One-Year Ratings Drift


Year of Issuance First Year Second Year Third Year Fourth Year Fifth Year
1995 1995-1996 1996-1997 1997-1998 1998-1999 1999-2000
1996 1996-1997 1997-1998 1998-1999 1999-2000 NA
1997 1997-1998 1998-1999 1999-2000 NA NA
1998 1998-1999 1999-2000 NA NA NA
1999 1999-2000 NA NA NA NA

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.

Figure 12: One-Year Ratings Drift By Stage


Of Maturity For All US Corporate Instruments10
40%
20%
0%
-20% -7% -6%
-19% -19% -16%
-40%
-60%
-80%
-100%
Year1 Year2 Year3 Year4 Year5

One-Year Ratings Drift


Year of Issuance First Year Second Year Third Year Fourth Year Fifth Year
1995 1995-1996 1996-1997 1997-1998 1998-1999 1999-2000
1996 1996-1997 1997-1998 1998-1999 1999-2000 NA
1997 1997-1998 1998-1999 1999-2000 NA NA
1998 1998-1999 1999-2000 NA NA NA
1999 1999-2000 NA NA NA NA

10 Includes bonds, bank loans and convertibles for USD issues of U.S. domiciled non-financial corporate issuers

Moody’s Special Comment 13


Liquidity Risk, A Self-Fulfilling Prophecy
Liquidity can evaporate as fast as investors lose confidence — which can happen quickly. While many
companies can ultimately survive a liquidity crisis, some may not because there is a point at which a lack of
liquidity can adversely affect solvency.
As noted above, the ratings drift for convertible securities has been negative, and credit quality among
high-yield issuers has eroded overall over the last few quarters in the face of more volatile market condi-
tions, deteriorating liquidity, and evidence that many national economies are experiencing slower growth.
Thus, it is especially important for investors to remain alert to each issuer’s liquidity position and vulnera-
bility to cyclical or other shocks.11
Credit concerns permeate the investor and banking communities. The Commercial Paper (CP) dealer
community in particular has become less willing to provide liquidity for deteriorating credits and this
includes the sale of new CP and — in rare cases — the repurchase of outstanding CP. Furthermore, the
consolidation of financial institutions has had an adverse effect on liquidity due to the more limited num-
ber of “market makers”. In the lower end of the rating spectrum, there is increasing evidence that banks
have been slow and or reluctant to roll over maturities and to amend covenants.
Stock market volatility has also adversely affected the ability of certain issuers to fund themselves.
Market participants have commented that even some blue chip issuers facing cyclical pressure have found
it more difficult to maintain or expand their full placement volumes. Moreover, there has been little
receptivity to “story paper”.

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.

14 Moody’s Special Comment


Case Study I: Xerox, A Lesson In Liquidity
The CP market has been hit by a number of “credit events” over the past twelve months. In the
case of Xerox, a liquidity crunch was created by a combination of the company’s weak operating
results and rumors of possible bankruptcy filings that started in October in London. The reluctance
of investors to take even short-term paper into inventory to help transition the company out of the
CP market and into the banks accelerated the loss of CP investor confidence. Xerox was increas-
ingly funding itself with short-term debt because it was, in part, refinancing maturing medium-term
notes (MTN’s) in the CP market.
Investor confidence waned and caused Xerox to lose access to the CP market. Doors slammed
shut fast, and consequently Xerox’s banks were called upon to fund maturing CP. Fortunately, the
company had an oversized revolving credit of $7 billion, which exceeded the peak CP usage prior
to the company’s travails. Following Moody’s downgrade of the company’s senior unsecured debt
to Ba1, Xerox drew down the rest of its $7 billion revolving credit agreement.
Xerox’s credit agreement was written as a strong investment-grade agreement in 1997. Its
credit agreement did not require the company to represent as to no material adverse change
(MAC) on borrowings subsequent to the initial closing, and included only a minimum consolidated
tangible net worth test of about $1 billion. Such room, negotiated when the company was an A-
rated company, has since been whittled down to the current cushion of $700 million by subse-
quent restructuring charges and operating losses.
Note that the existing credit agreement matures on October 2002, before the April 2003
put, at an accreted 64.89 on the convertibles. Refinancing will be necessary - potentially on a
secured basis — but this could be complicated by the terms of the senior notes that limit the
granting of liens.
Other contracts had rating decline triggers. Because Xerox’s ratings fell below investment-
grade (now at Ba3 Moody’s), certain derivative contracts and stock-put options were triggered,
exacerbating the company’s plight. This has caused the company to have to renegotiate certain
credit facilities, including a $411 million term receivable securitization and a $315 million trade
accounts receivable securitization facility, and to make payments to counterparties under certain
derivatives. This resulted in the further use of cash and the reduction of credit availability. To the
extent that additional downgrades occur, additional renegotiations could be required, however, the
liquidity impact would be manageable in light of the company’s $3.1 billion cash position following
a series of asset sales.

Moody’s Special Comment 15


Case Study II: Amazon.Com, A Lesson In Company-Specific Risk
Moody’s assigned a Caa3 rating to Amazon.com’s $1.25 billion convertible subordinated notes
when they were issued in January 1999. Notwithstanding Amazon’s significant market capitaliza-
tion at the time — Moody’s cited that:
1.Amazon.com was unlikely to generate positive cash flow for at least another two years,
2.The company was expected to invest heavily in fixed assets, intangibles and working capital in
the near term, and
3.The ratings reflected the equity-like risk being taken by the debt holders as a result of the com-
pany’s decision to finance its growth through the debt markets, and the uncertainty of the
company’s future growth and operating strategies.
The conversion price of the notes was set at $78.03, a 27% premium over the stock price. Note
the run-up in the company’s stock price from $20 in November 1998 to $61 when the convertibles
were issued in January 1999. The market equity of the company when the notes were issued was
$11 billion. Notably the stock was not priced off of a discounted cash flow valuation but was driven
by market demand for “story paper”. Not long after issuance, for a brief period in April 1999 and
again in the 4th quarter of 1999 (following the announcement of new Internet “stores” and in antici-
pation of the holiday season), the stock price exceeded the conversion price. The stock price
responded positively to earnings announcements in the first quarters of both 1999 and 2000, as
well as to investments in other businesses such as Living.com and Pets.com.
But it wasn’t long until the “story” began to unfold and the company’s bond and stock prices
drifted downward. Market euphoria was tempered by the fact that many of the fundamental oper-
ating risks that Moody’s initially identified in assessing the convertibles as debt of a start-up com-
pany were realized. Moreover, with the passage of time, it became clear that at least $250 million
of proceeds from Amazons’ various debt issues were invested in businesses that produced virtual-
ly no returns. Consequently, most of the value of this investment was ultimately lost.
As you can see from the chart below, until mid-2000, the volatility and run-up in stock price
caused the equity option component of the convertible to dominate the security’s pricing (i.e., the
price of the convertible moves in lock step with the stock price). After that point, the steep and
sustained drop in the stock price below conversion caused investors to become skeptical regard-
ing the upside potential. The bond price begins to fall less severely than the stock price, as the
market discounts the equity option and views the convertible much like a straight bond. This trend
is further evidenced by the explosion of the premium, or the percentage over market value that
investors pay for a convertible’s shares, from a low of 11% in June 2000 to 91% at the end of the
year.12 Now well into 2001, Amazon is becoming more focused on harvesting its existing opera-
tions and investments, but concerns remain regarding revenue growth and ultimate profitability.

12 Premium = (Convertible Price - Parity)/Parit


Parity = Market Stock Price x Number of Shares per Bond (expressed as a percentage of par)
The number of shares per bond is fixed at issuance, so as the stock price drops, so does parity. If the convertible price does not
fall as steeply (i.e., because it is being valued as straight debt), the premium will rise.

16 Moody’s Special Comment


Figure 13: Conversion Unlikely As Market Assesses Amazon’s Operating Risks

Amazon (AMZN - Caa1)


US $125M 4.75% Convertible Sub Notes

$120 $160
▲ ▲




▲ $140
▲ ▲
$100 ▲
■ ▲ ▲
■ ■

■ ▲ ▲ $120
■ ▲ ▲ ■ ▲ ▲
▲ ▲
$80 ■ ▲▲ ▲ ▲ ▲ ■
▲▲ ■ ▲ ■ ▲
▲ ▲ ■ ■ ▲ ■ ▲ ▲
▲ ▲▲
▲▲ ▲▲ ▲▲
■ ▲■
▲▲
▲ ▲ ▲ ▲▲
■ $100
■ ▲ ■
■ ■
▲ ■ ■ ▲▲ ■ ■
■ ■■ ▲
▲▲■ ■ ■ ▲▲
■ ▲ ▲ ■ ■
■ ■ ■ ■ ■ ■
■ ■ ▲ ▲▲
■ ■ ■ ▲ ▲ ■ ■■ ▲▲
$60 ■■ ■
■ ▲ ■ ■ ■ $80
■■ ■ ■ ▲ ▲
■■
■■ ▲ ■ ■ ▲▲ ▲▲▲▲
■ ■ ▲▲ ▲ ▲
■ ■ ■ ■ ▲▲ ▲
■ ▲ ■ ▲▲
■■■■ ▲ ▲ ▲ $60
■▲ ▲
$40 ■■ ■ ▲ ■ ▲
■ ■ ■■ ■ ▲ ▲
■ ▲
■■ ■
■ ■ ■ ■ ■ ■ ▲▲ $40
■ ■
■■

■■■
$20
■■ $20

$0 $0

■ Stock Price ▲ Bond Price

Amazon (AMZN - Caa1)


US $125M 4.75% Convertible Sub Notes

160% 100%
▼▼ 90%
140% ●

80%
● ●
120% ● ●

● ● 70%
100% ● ● ● ●
● ● ●

● ▼ 60%
● ●● ●
● ●
●● ● ● ● ● ●● ▼
● ● ● ● ● ● ● ● ▼ ▼
80% ● ●● ● ●● ● 50%
●● ● ● ●
● ● ▼ ▼▼
●●●● ● ●
● ●

●● ▼▼
● ● ▼ 40%
▼ ▼
60% ●
● ● ● ▼
▼ ▼● ▼ ●●
▼ ▼
▼ ▼ ▼ ●
▼▼ ▼

▼ ●●▼ ▼
●▼ ▼● ●
●●▼ ● 30%
▼ ▼▼▼ ▼▼ ▼ ● ●●
40% ▼ ▼▼ ▼ ● ● ● ●
▼ ▼ ▼ ▼▼▼ ▼▼▼ ▼ ▼ ▼ ● ●●
▼▼ ▼ ▼▼ ▼▼ ▼
▼ ▼ ▼▼ ▼ ▼▼ ▼ ▼
▼ ●●● 20%
▼ ▼ ▼▼▼ ▼▼ ▼ ▼▼ ▼▼
▼ ▼ ▼ ▼▼▼
20% ▼▼ ▼ ●●
▼ ▼ ▼
10%

0% 0%

● Parity ▼ Premium

Moody’s Special Comment 17


Case Study III: AMF Bowling, A Lesson In Default
The AMF example highlights several important points:
1. Convertibles can be used as a platform for leveraging
2.To the extent that proceeds of the convertibles are used to make acquisitions, then those
acquisitions need to produce good returns, and
3.Convertibles can quickly bear the brunt of inferior returns and under certain circumstances
take on equity like risk compared with other debt in the capital structure.
In May 1998, AMF Bowling (a holding company) placed $1.125 billion of zero coupon con-
vertible debentures. The net proceeds of the offering were approximately $275.6 million and
were contributed by AMF Bowling as equity to AMF Bowling Worldwide (the operating company).
AMF Bowling Worldwide used the bulk of the convertible proceeds to repay senior bank indebt-
edness under its credit agreement. Such repayment and resulting ability to reborrow enabled the
company to incur additional indebtedness under the credit agreement to fund the company’s
ongoing bowling center acquisition program.
As you can see from Figure 14, the convertibles were issued at a time when the stock price
was near its high. But a confluence of events, including a weak Asian economy that depressed
sales of bowling equipment and the lackluster performance of acquired bowling centers, pro-
duced extremely weak returns on assets, which was troublesome given the company’s extremely
heavy debt burden and high level of intangibles.
Slightly more than one year after issuance, in July 1999, AMF completed a rights offering and
tender offer for the convertibles. AMF Bowling raised $120 million in equity capital pursuant to
the rights offering. Under the tender offer, 46% of the principal amount at maturity of the con-
vertibles was accepted for payment at a substantial discount from the accreted value (although
notes representing 88% of the principal amount at maturity were tendered). Excess equity pro-
ceeds of $30 million were contributed as equity to AMF Bowling Worldwide to enable it to fund
additional acquisitions.
As you can also see from Figure 14, AMF could not grow its way out of its problems. The
additional acquisitions absorbed cash and produced inferior returns. In fact, the second graph
shows that: 1) the returns were declining even as the company was still continuing to make
acquisitions, and 2) returns were declining prior to the issuance of the convertibles.
The second graph in Figure 14 depicts the dollar amount of spending for acquisitions and
capital expenditures. Such spending continued on a vigorous pace to $304.1 million on a last
twelve-month basis at June 1998. At the same time, returns were rapidly declining as measured
by EBITA/assets. The returns are somewhat understated because the chart does not depict
“proforma” EBITA/assets considering the effects of rapid aggregation. Moreover, results have
not been adjusted for charges taken in 1999 in connection with the planned downsizing of the
bowling products business.
The poor returns coincided with the rapid drop in the company’s stock price. Cash con-
straints were so severe at the time of the tender offer that acquisition spending was curtailed. In
the later part of 2000, the company was unable to meet debt service requirements under both its
bonds and its bank debt.

18 Moody’s Special Comment


Figure 14: High Spending, Weak Returns, Cash Constraints,
And Stock Slump = Default For AMF

AMF Bowling, Inc.

$35

$30

$25
Price Per Share

$20

$15

$10

Placement of Conv. Rated Rights offering completed 7/29/99


$5 B3 5/12/98

$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

4.00% $243 Rights Offering Completed $200

3.00% 7/29/99 $150


3.70%
Placement of Conv. 1.51%
2.00% $52 $100
Rated B3 5/12/98
1.00% $50
$57 $67
0.00% $0
-1.43%
-1.00% -$50

-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

ROA CAPEX Acquisition and CAPEX

Moody’s Special Comment 19


Of Convertible Debt Securities
Critical Issues in Evaluating the Creditworthiness
Special Comment

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