Bond Games

George S. Oldfield
Corporate debt indentures are complex contracts that include a variety of
restrictions and options. On one side, an issuing corporation can engineer
game-based transactions to escape covenant restrictions or capture option
value for its stockholders. On the other side, bondholders can form coalitions
to resist a corporation’s endeavors and capture option value for the coalition.
This article analyzes several types of such strategic debt transactions. The
examples show that corporate debt games can strongly influence corporate
bond prices.

C
orporations can issue a myriad of financial
claims—some pure equity, some straight
debt, and some that combine elements of
both. All the different types of claims have
embedded option features. Direct options are con-
veyed through specific contract provisions; indi-
rect ones are conveyed through claims in
restructuring, bankruptcy, and liquidation. The
embedded options, although more or less clear in
their apparent influence on pricing, can also have
significant but less obvious valuation conse-
quences. In particular, normal conflicts between
issuers and investors can generate strategic trading
games in which debt prices deviate substantially
from their apparent option-based values even
though a default is not part of the game. I show how
some of these games work.
Option-pricing techniques have brought an
important element of realism to corporate claim
pricing. Game analysis takes valuation a step fur-
ther by showing how interested parties can find
strategies to neutralize or capture the option fea-
tures of other parties’ claims. These strategic trans-
actions can strongly influence a corporation’s bond
values throughout an issue’s life.
In times of corporate financial distress, debt
covenants are important factors in claim valuation
(see Gilson, John, and Lang 1990). Priority, collat-
eral, voting rights, and ownership distribution can
substantially influence a claim’s payoff. Although
such end-game analyses are an important feature of
corporate finance, the focus in this article is differ-
ent. Here, the emphasis is on games that occur in the
normal course of business. This angle is important
because many informed commentaries assert that
George S. Oldfield is Richard S. Reynolds Professor of
Finance in the Graduate School of Business, College of
William and Mary, Williamsburg, Virginia.
corporate bond games start only with the likelihood
of a substantive default (see Myers 2001). To analyze
corporate debt pricing, the potential for bond games
must be included throughout the life of the debt
instrument. A corporation can manipulate the value
of a debt contract to its shareholders’ benefit, and
creditors’ loss, in the normal give and take of bond
trading.1 Thus, active corporate debt investing
requires both analytical and negotiating skills in the
ordinary course of portfolio management.
Corporate debt markets are not staid and quiet
venues in which a few bonds are shuffled about
each day. In 2000, about $507 billion of new non-
convertible corporate debt instruments were
issued in the United States (Bond Market Associa-
tion 2001). About 400,000 corporate issues, with a
value of almost $3.5 trillion, are outstanding (“Big
Board Backpedals . . .” 2001). In secondary markets,
trades among institutions and dealers predomi-
nate. A round lot is $1 million in principal value,
and 100-lot orders are common. Although trading
in any individual issue is sporadic, each primary
issue generates a cascade of secondary trades, in
both the new bonds and other issues, as portfolio
managers swap new bonds for old ones and dealers
find the old bonds new homes. These secondary
trades, distributed across hundreds of thousands of
different corporate debt issues, create “flow trad-
ing” in the secondary market. On top of this flow
trading, large transactions generated by informa-
tion about issuers, “squeezes,” “corners,” exchange
offers, and structured transactions (defined later)
occur daily. I analyze the incentives and mechanics
of several types of information trading and the
impact of this trading on corporate bonds’ values.
A difficult or contested strategic corporate
bond transaction does not denote a disequilibrium
between an issuer and its investors. Rather, it means
that a state of nature that was evaluated as a

52 ©2004, AIMR®

low-probability outcome at the time of issue has
come to pass and both the issuer and the investors
are playing out their predictable roles in this state.
No indenture contract is perfect. Arbitrageurs or
issuers simply take advantage of the opportunities
afforded in certain states of nature when they occur.
All informed market participants understand that
various types of games—squeezes or “freeze-
outs”—are an inherent part of the corporate bond
market’s natural equilibrium. A market equilibrium
could not occur without interested parties trying to
capture profitable opportunities as they arise.
Hedge funds, “vulture investors,” dealer pro-
prietary trading desks, and convertible bond arbi-
trageurs actively seek profits from strategic
corporate debt trading. Troubled corporations, or
those that want to capture short-term gains for their
shareholders, carefully monitor chances to freeze
out indenture covenants or force exchanges and con-
versions.2 Although such an occurrence is unlikely
for any single new issue, the existence of hundreds
of thousands of corporate bond issues creates daily
or weekly strategic trading in secondary corporate
bond markets. The trading by arbitrageurs in these
situations is an important force in corporate bond
pricing for both old and new bonds. Therefore, ini-
tial investors in any corporate bond issue must be
aware of the possible eventual consequences of the
various covenants in a corporate indenture.
Many strategic transactions are privately nego-
tiated and virtually invisible to outside observers.
In addition, many apparently ordinary exchange
offers, tenders, and conversions contain a game-
based component that only intensive analysis can
uncover. For example, the “sinking fund squeeze”
described later appeared to be a simple redemption
by the issuer followed by a private placement. In
fact, the structured transaction presented in that
example is only one of many arbitrage trades under-
taken in a dealer’s proprietary trading activity.
The Exchange Game
A corporation has a special type of fiduciary obli-
gation to its shareholders but a lesser contractual
responsibility to its creditors. To protect them-
selves, creditors frequently require extensive and
restrictive covenants in a debt indenture before
providing funds to the corporation (see Smith and
Warner 1979). Although these terms are viewed as
a necessary cost of raising money when the instru-
ments are issued, a corporation may later find cer-
tain covenants to be too limiting vis-à-vis desired
corporate initiatives. If the bonds are held by a few
creditors—say, as a result of a private placement—
negotiations are frequently used to alter the offend-
May/June 2004
Bond Games
ing contract terms. If the bonds are widely held or
the creditors demand costly terms for relaxing a
covenant, the issuing corporation can engineer a
freeze-out exchange offer or a more creditor-
friendly defeasance.
Freeze-Out Exchange Offer. A simple exam-
ple illustrates how a freeze-out exchange offer
works. Consider a corporation with asset value V,
where V = $1 billion. The corporation is financed
with straight debt, labeled B, with market value
$550 million split among 5.5 million bonds that
currently trade at par value of $100 each. The bonds
have an 8 percent coupon and no current redemp-
tion provisions, but the indenture agreement con-
tains a restrictive covenant that the corporation
wants to escape. Assume that a two-thirds vote of
the bonds is necessary to change the covenant. (A
super majority is a common requirement for inden-
ture changes, although simple majorities are fre-
quently required for changes that do not affect
payment terms.) Finally, assume that the bond
owners are so dispersed or recalcitrant that secur-
ing a two-thirds vote to change the covenant would
be quite difficult. In this case, the corporation can
execute a freeze-out.
To engineer a voluntary exchange that nullifies
(freezes out) the restrictive covenant, the corpora-
tion can foist a “prisoner’s dilemma” on the current
bondholders.3 Suppose a new bond issue is offered
to existing bondholders in exchange for the old
bonds, one for one. The new bonds have an 8.5
percent coupon and the same redemption features
and maturity date as the old ones but no restrictive
covenant. Any and all tendered bonds can be
exchanged. However, the offer has a proviso: Any
old bond tendered in the exchange constitutes also
a vote by that bond to remove the covenant in the
old bond’s indenture contract. Thus, if a bond-
holder does not tender and two-thirds of the old
bonds are tendered by other bondholders, the hold-
out bondholder is stuck with the old bond and its
8 percent coupon and no covenant whereas the ten-
dering bondholders get a new bond with an 8.5
percent coupon.
If bondholders cannot form a coalition against
the offer, each ith bondholder faces the hypotheti-
cal payoff in Table 1. The current market value of
an old bond is $100. All other prices are for illus-
tration. Only the relative magnitudes are impor-
tant. Although an 8.5 percent coupon was used in
this illustration, the corporation can choose what-
ever coupon is necessary to make the relative
prices work.
53
Financial Analysts Journal
Table 1. Freeze-Out Game Outcomes
Bondholder i
Does Does Not
Two-Thirds Tender Tender
Do tender $99 $98
Do not tender $101 $100
The columns in Table 1 represent the choices
of an individual bondholder. The rows show what
other bondholders might do. The number in each
cell gives the hypothetical bond value of the
exchange offer to the ith individual. For example,
if bondholder i tenders (the left column) and two-
thirds of other bonds are tendered too, all the ten-
dered bonds are exchanged for new bonds with a
value of $99. The higher coupon does not quite
compensate for the less restrictive covenant. If the
ith bondholder tenders and most other bonds do
not, investor i gets a new bond that is protected by
the old bond indenture. Thus, the new bond is
worth a premium $101 value because it has a higher
coupon and the old bond’s covenant is still in force.
If individual i does not tender (the right column)
but two-thirds of the old bonds make the exchange,
the ith bondholder keeps the old bond with the
lower coupon and loses the covenant. If bond-
holder i does not tender and most other bonds are
not tendered either, the covenant stays in force and
the old bonds keep their $100 price.4
Table 1 clearly shows from the payoffs in
terms of bond value that each bondholder alone
facing the same decision should tender old bonds
for new ones. The dilemma is that each bondholder
would be better off if no bonds were tendered. The
incentive in the dilemma forces the exchange,
which removes the covenant. If bondholders are
dispersed and remain uncoordinated, the corpora-
tion can capitalize on this disorganization to sub-
vert the restrictive covenant. This act can be the
first in a more complex type of transaction that is
discussed in the section on convertible bonds. Of
course, if a corporation makes a practice of this
type of freeze-out, the inclusion of restrictive cov-
enants in future bond issues will bring no value
premium because forced exchanges will be
expected.5 Also, the increase in coupon required to
engineer the game can make the interest expense
too high to justify freezing out the covenant. In
addition, a coalition of bondholders can defeat the
corporation’s game by coordinating their actions,
not tendering and thus avoiding the prisoner’s
dilemma. Therefore, corporations with dicey rep-
utations can be forced into private placements or
54
bank loans in which a small group of creditors
carefully monitors the corporation’s action and
acts together to prevent corporate games.
In December 2002, Qwest Communications
International Corporation executed a coercive
exchange offer to reduce its aggregate indebted-
ness. Some features of the exchange offer were
similar to a standard freeze-out. Qwest sought to
exchange new notes for 11 separate debt instru-
ments it had previously issued. The offer, a series
of private placement notes, was made only to the
qualified institutional and non-U.S. holders of the
targeted outstanding notes and debentures. The
exchange offer had two tiers. In the first tier, up to
$6.9 billion in old notes and debentures could be
swapped for specified new notes with lower prin-
cipal values and longer maturities but higher cou-
pons and claim priorities. The second tier offered
holders of the remaining $6 billion in old instru-
ments tendered one-for-one exchanges, old notes
and debentures for new notes, in which the old and
new notes had the same principal, maturity, and
coupon but the new notes had a higher claim pri-
ority. No changes were proposed for indentures of
the old instruments not tendered. Thus, $12.9 bil-
lion in old notes and debentures were qualified for
the exchange in two tiers, with the target amount
being $6.9 billion of the old securities.
Consider how the exchange offer coerced the
old note and debenture holders to tender those
instruments. On the one hand, if old notes or deben-
tures were accepted by Qwest in Tier One, higher
coupons and claim priorities were granted in the
new notes. Because a bankruptcy filing was a dis-
tinct possibility, the new notes offered both
increased current income and enhanced potential
workout benefits. Moreover, although the princi-
pal discount was substantial, the new notes were
structured to trade at par whereas the old notes and
debentures traded at a large discount to par
(because of Qwest’s financial difficulties). Thus, the
principal “haircut” was about the same as the cap-
ital loss on the old instruments for current inves-
tors. Even if tendered instruments were accepted
by Qwest only in Tier Two, the claim priority was
better in the new notes. Holding the old notes and
debentures meant that claim priority in bankruptcy
was reduced by the amount of new notes issued.
Hence, although the old indenture contracts were
not changed by a direct vote in the exchange, the
effect of the exchange was to reduce the value of
any untendered instruments.
A group of institutional investors that owned
the $4 billion of the various old Qwest issues sued
Qwest to prevent the exchange offer, which they
termed coercive and deficient in value. The ability
©2004, AIMR®
 Bond Games

of such a group to organize and file suit demon-
strates substantial coordination and resistance
among the holders of the old instruments. Never-
theless, the suit was dismissed and the exchange
offer was completed on 26 December 2002. Results
of the exchange offer are shown in Table 2.
The issuer of the original instruments was
Qwest Financial Corporation (QFC), a wholly
owned finance subsidiary of Qwest. The new notes’
issuer was Qwest Service Corporation (QSC),
another wholly owned subsidiary of Qwest and one
with substantial real assets. The targeted QFC notes
and debentures are listed first in Table 2. Reading
across Table 2 provides the reduction in principal
value proposed for each issue, the size of the original
issue, and the results of the exchange offer. For
example, from Panel A, for each $1,000 in principal
value at 5.875 percent QFC notes due in 2004, prin-
cipal amount of $825 at 13 percent QSC notes due in
2007 was offered. The total old issue was $1.25 bil-
lion, of which $287 million (23 percent) was tendered
and accepted. The result was a reduction in the
indebtedness of Qwest by $50 million ($287 million
– $237 million) in this issue alone. (Tiers One and
Two are various issues in Panels A, B, and C.) The
last line of Table 2 shows that, overall, Qwest offered
exchanges for up to $12.903 billion in principal value
of old instruments, $5.238 billion was tendered, and
investors received in exchange new notes with prin-
cipal value of $3.3 billion. The reduction in Qwest’s
total book indebtedness was $1.938 billion.
Despite the improved claim priority in the new
notes, holdouts were probably anticipating more
favorable treatment in a bankruptcy proceeding if
such a filing should occur. Corporations frequently
attempt freeze-outs during financial distress to
reduce indebtedness and eliminate the claims of
potentially troublesome holdout creditors during a
financial restructuring.6
Indenture Escape through Defeasance. A
defeasance is a bond transaction in which a com-
pany effectively refunds a bond issue without retir-
ing it. To accomplish a defeasance, a corporation
establishes a defeasance trust, purchases govern-
ment (or agency) bonds in sufficient quantity to
fund its own bond issue, and delivers the collateral
to the defeasance fund’s trustee. The liability of the
trust is the obligation to pay the defeased bonds’
principal and interest. The trustee assures that the
timely payment of interest and principal from the
government (or agency) bonds’ payouts goes to the
corporation’s bondholders.
A legal defeasance is one in which the bond
indenture allows the corporation to escape its inden-
ture covenants through the transaction. For exam-
ple, a legal defeasance can be used to extinguish a
corporation’s obligation under a call-protected pre-
mium issue or to avoid some other covenant that
restricts corporate endeavors. With a legal defea-
sance, the defeasance trust is immune to corporate
bankruptcy and the defeased bonds’ ratings and
prices increase.

Table 2. Qwest Freeze-Out Results

For Each New QSC
$1,000 Outstanding Tendered Notes Issued
QFC Instruments to be Exchanged Principal (millions) (millions) (millions)
A. Exchanged for 13% QSC notes due in 2007
5.875% Note due 2004 $825 $ 1,250 $ 287 $ 237
6.250% Note due 2005 750 500 79 59
7.750% Note due 2006 680 1,250 369 251
$ 3,000 $ 735 $ 547
B. Exchanged for 13.5% QSC notes due in 2010
6.375% Note due 2008 $625 $ 584 $ 280 $ 175
7.000% Note due 2009 635 1,985 1,047 665
7.900% Note due 2010 640 1,746 1,001 641
7.250% Note due 2011 635 2,250 992 630
$ 6,565 $3,320 $2,111
C. Exchanged for 14% QSC notes due 2014
6.000% Debenture due 2018 $525 $ 393 $ 121 $ 64
7.625% Note due 2021 540 478 230 124
6.875% Debenture due 2028 545 1,477 590 322
7.750% Note due 2031 545 990 242 132
$ 3,338 $1,183 $ 642

Total (millions) $12,903 $5,238 $3,300

May/June 2004 55
Financial Analysts Journal
An economic defeasance (or defeasance in sub-
stance) does not allow the corporation to escape its
indenture covenants. The defeasance trust in this
case may not be bankruptcy immune, but the
defeased bonds usually trade a bit richer because
of the pledged government collateral.
A defeasance in substance generally involves
discount corporate bonds. The corporation estab-
lishes a defeasance trust and puts into the trust
government bonds that yield at least the coupon
rate on its own issue. The corporation realizes an
immediate accounting gain that equals the differ-
ence between the actual price of the government
bonds and the principal value of its own bonds.
Although a defeasance in substance does not release
a company from its indenture agreement (unless it
is also a legal defeasance), it does release the com-
pany from interest payments, which are covered by
the trust, and it provides early recognition of a gain.
In addition, balance sheet debt is reduced. Thus, a
defeasance in substance is a transaction that has
more accounting benefits than real ones.
The obvious alternative to defeasance with
government bonds is for a company to buy and
retire its outstanding debt. Because corporate bonds
sell for less than government bonds, buying its own
bonds and retiring them should normally be
cheaper for a corporation. However, several condi-
tions restrict this simple solution. First, companies
must pay a tax on cancellation of indebtedness for
buying discount bonds. Second, information gets
around so fast in corporate bond secondary markets
that bondholders can hold out against selling their
bonds. The buy orders alert the bondholders and
dealers to the corporation’s attempt to retire its
bonds, and the bondholders try to hold back large
blocks. The intent on the part of the bondholders is
to offer the bonds to the corporation eventually at a
price high enough to capture virtually all the retire-
ment or defeasance benefits for the bondholders.
So, although a company must pay a higher price
for government bonds than its own bonds would
command without such a bondholders’ corner on
the market, the actual cost of a defeasance with
government bonds can be lower. Such a defeasance
defeats a corner because the issuer is not bidding for
its own bonds. Moreover, if the company anticipates
a corner attempt, it can try a freeze-out.
The Sinking-Fund Game
A sinking-fund corner, or a squeeze on the issuer, is
the opposite of a freeze-out. Whereas in a freeze-out
the corporation captures value from its disorga-
nized creditors, in a sinking-fund corner, coordi-
56
nated action by creditors (usually orchestrated by
an arbitrageur) captures value from the company.
Sinking-fund provisions can work in a variety
of ways. One type of sinking fund is an escrow
account into which the corporation pays a fixed
amount according to a specified schedule. The
account accumulates until the amount in the
escrow account at the bond’s term is sufficient to
pay the principal value of all the issue’s bonds. In
this case, the sinking fund does not cause early
bond redemption but the escrow account does
lessen the bonds’ risk. This type of sinking fund is
now rare.
Another, much more common, type of sinking-
fund schedule requires the issuing corporation to
redeem a fraction of the issue periodically. The
indenture can specify a lottery-determined call for
bonds at a fixed price or provide the corporation an
option either to buy the required number of bonds
with a market bid or to retire them through a fixed-
price lottery. The company may also be able to sink
double the scheduled number (or more) on speci-
fied dates. Sinking-fund redemption prices are fre-
quently at a premium over par. Usually, for both
callable and sinking-fund bonds, for an initial
period after issue (several years), the bonds are
protected from redemption.
Cornering Sinking-Fund Bonds. A profit-
able corner is sometimes possible when a corpora-
tion has the option to sink bonds at market price
or at a fixed indenture redemption price. If the
bonds currently trade below the redemption price,
a potential arbitrage situation exists. An arbi-
trageur tries to establish a corner by buying sub-
stantially all the bonds below the fixed indenture
price. Then, the option’s value is captured by the
arbitrageur because the bonds are never offered by
the arbitrageur to the issuer below the indenture’s
redemption price. The whole transaction can be
accomplished with no significant capital outlay.
This activity resolves a puzzle raised by Dunn and
Spatt (1984, p. 420) regarding coordination in
sinking-fund squeezes. The mechanism for corner-
ing the market involves a structured transaction
that is executed by an arbitrageur.
A sinking-fund corner transaction can work in
a very direct manner. In one actual transaction sev-
eral years ago, an arbitrageur established a special
purpose entity (SPE) to buy a large block of a cor-
poration’s debt. These corporate instruments com-
posed most of the SPE’s assets. The SPE also set up
buys of zero-coupon U.S. Treasury securities with
appropriate maturities as necessary (discussed
later). Simultaneously, the SPE marketed issues of
tranches or serials of coupon-bearing securities
©2004, AIMR®
 Bond Games

called “derivative debentures” or “collateralized Table 3. Example’s Derivative Serial Debenture

corporate obligations.” The derivative debentures Structure
were collateralized with the entity’s purchased cor- Principal Amount
porate securities, and the zero-coupon T-bonds Maturity Coupon Rate (millions)
were used to fill the asset structure correctly. The 1990 8.375% $ 6.648
deal was structured so that the cash flows that 1991 8.500 11.875
accrued to the entity’s assets were paid to the 1992 8.500 11.875
debenture owners on a parallel schedule. Any call 1993 8.600 11.875
or default risk was passed through the entity from 1994 8.600 11.875
the sinking-fund collateral to the derivative deben- 1995 8.800 11.875
tures. Residual earnings on the SPE’s assets accrued 1996 8.875 11.875
to the SPE’s equity owners. In this regard, the 1997 8.950 11.875
entity’s capital structure closely resembled the 1998 9.250 11.875
setup of a REMIC (real estate mortgage investment 1999 9.300 11.875
conduit), with mortgage collateral financed 2000 9.300 11.875
through several tranches (see Oldfield 2000). 2001 9.300 11.875
The important features of the corner transac- 2002 9.300 11.875
tion were as follows. First, the corner collateral
comprised both corporate securities and, as neces- The derivative debentures were structured as
sary, zero-coupon U.S. Treasuries. The Treasuries serial bonds with principal amounts in millions of
made the credit quality of the combined collateral dollars, and each maturity tranche matched a sink-
slightly better than the quality of the sinking-fund ing-fund redemption date. In current parlance, the
corporate debt portion alone. Second, the periodic serial tranches were “collateralized debt obliga-
corporate redemption payments on the sinking- tions” with tranching based on the sinking-fund
fund bonds and the zero-coupon bond maturity dates of the issue rather than on credit enhance-
payments were transformed into tranches of serial ment based on payment priority from a portfolio of
bonds with different maturities. Because the entity corporate instruments. Coupon payments at the
owned virtually all of the sinking-fund issue, the stated rate were set to be paid semiannually to
sinking-fund uncertainty of an individual corpo- serial owners on 16 May and 16 November. Each
rate debenture was converted into a much more serial matured on 16 November of the indicated
certain cash maturity payment for the large block year, which matched a sinking-fund redemption
of collateral. This lump sum became the maturity date. The collateral’s call provision was passed
payment of a tranche or bond serial. Third, the through to the serial bonds so that if the sinking-
various maturity tranches could be sold with dif- fund collateral was called (all or none for this issue),
ferent coupon rates and prices by the SPE. Thus, the all serials were called simultaneously. Each serial
derivative debentures could be tailored to different had a different initial offer price.
customers’ needs. In effect, the corner collateral The way this sinking-fund corner trade was
could be resold in a price-discriminating serial structured is outlined in Figure 1. All trades went
bond offering. through the arbitrageur. The SPE’s balance sheet is
at the top, and below it are the transactions (and
Sinking-Fund Structured Transaction. A prices) used to set it up. The arbitrageur negotiated
sinking-fund corner transaction was structured in a price for the sinking-fund bonds with each bond-
the spring of 1986. In it, the corporate collateral was holder separately. Each received a slightly different
approximately $146 million in principal value of a price as a result of intense haggling. (This aspect
large industrial company’s debentures with an 8 supports Dunn and Spatt’s conclusion that bonds
percent semiannual coupon and 2002 maturity. The from the same sinking-fund issue can have different
collateral 8 percent coupon debentures of 2002 were prices for different owners.) The weighted-average
combined with about $11 million market value of price is shown in Figure 1.7 The zero-coupon Trea-
stripped U.S. Treasuries to form 13 derivative suries were bought in the dealer market. The entity
maturity tranches. The maturity, coupon, and prin- bought the collateral from the arbitrageur and
cipal schedule for the derivative bonds is given in simultaneously issued the derivative serial bonds
Table 3. Note that the coupon rates on the deriva- and equity to the arbitrageur to finance its asset
tive debentures increased with maturity although purchase. The arbitrageur then sold the serial bonds
the collateral had a fixed coupon. The Treasury to institutions at a single public offer price for each
strip maturities made up the difference. serial but different prices for different serials. This

May/June 2004 57
Financial Analysts Journal
Figure 1. Transaction Flow of Example Sinking-Fund Corner
(millions)
Special Purpose Entity
Sinking-
Fund Bonds
$126.000
Zero-Coupon
Treasuries
$17.600
Collateral Sellers
Arbitrageur
Sinking-
Fund Bonds
$124.458
Zero-Coupon
Treasuries
$17.555
practice allowed for potential price discrimination
without liquidating the collateral position directly.
Such price discrimination can be an important
source of a corner’s profit (see Oldfield 2003).
Figure 1 shows that the arbitrageur had two
potential sources of profit in the transaction. The
first source was trading profit. The arbitrageur was
a dealer firm whose corporate trading and syndi-
cate desks could make spread profits on the trades.
The trading profits were split as $1,542,000 on
sinking-fund bonds, $45,000 on zeroes, and $99,000
on the derivative serial bonds, for a total of
$1,656,000 in trading with the SPE. The second
source was the entity’s equity that would be bought
and retained by the dealer. Although the dealer
would pay the SPE only $50,000 for the equity, its
estimated value was $1,710,000. The resulting total
potential profit from the sinking-fund corner to the
dealer was $3,316,000.
The entity’s equity claim requires further
explanation. As a separate corporation, the entity
that issues derivative securities also sells a residual
claim of ownership. The equity claim receives any
residual flows into the subsidiary in excess of the
payments due to the debenture owners. In the
worst case, no excess is realized at any time during
the subsidiary’s life. In other cases, however, sig-
nificant excess flows occur. In essence, if call or
accelerated redemption payments flow into the
subsidiary, the payments due debenture owners
are less than those realized by the subsidiary. In
those cases, the equity claim is quite valuable.
In the example, the initial purpose of the
sinking-fund bond corner was to sell the entity’s
debentures for more than the collateral’s cost—
which created an immediate arbitrage profit. If the
58
Derivative
Serial Bonds
$143.550
Equity
$0.050
Derivative Buyers
Derivative
Serial Bonds
Equity $143.649
$1.710
arbitrageur retained the entity’s equity, apprecia-
tion in the equity’s value would provide additional
profit. Care must be used in modeling the tax status
of the equity, however, because the collateral
would generally be bought at a discount to par. The
serial issues would also be sold at a discount.
A sinking-fund corner can work only if the
collateral is assembled quickly and the derivative
debentures are sold immediately. In fact, they are
presold in a private placement offering. Otherwise,
the arbitrageur gets squeezed by both sides. On the
one hand, as they sense the nature of the deal,
potential derivative buyers demand a lower deriv-
ative debenture price to capture corner profits for
themselves. On the other hand, the arbitrageur must
enter simultaneous negotiations with the current
owners of the target corporation’s sinking-fund
bonds. They too can anticipate the arbitrageur’s
strategy and try to hold out for higher prices. The
arbitrageur must try to induce bondholders to sell
by playing some off against others. Also, if the target
corporation scents the deal, it can defeat the corner
by issuing attractive substitute bonds and use the
proceeds to defease the old bonds. Unless these new
bonds are included in the corner, buyers can take
them instead of the corner derivative debentures.
If the target corporation cannot increase the net
bond supply, the arbitrageur can offer the assem-
bled collateral back to the company at an attractive
compromise price instead of setting up and selling
derivatives in a structured transaction. To accom-
plish this trade, the corner arbitrageur must show a
creditable ability to sell derivative debentures. Oth-
erwise, the target corporation can simply wait while
the corner operator tries to finance the position.8
©2004, AIMR®

Convertible Debentures
Convertible debentures are complex equity-linked
claims issued by corporations. They are fixed-
income instruments that also convey to bondholders
a call option against the corporation for common
stock.9 In 2000, about $61.5 billion in various types
of convertible debentures were issued in the United
States (“Hedge Funds Drive …” 2001). To under-
stand a convertible debenture, one must analyze
both its indenture contract and the nature of the
other claims that the corporation has issued.
Asquith (1995) showed that most convertible deben-
tures are redeemed in a timely fashion, but he did
not address other potential anomalies, such as vol-
untary early conversion, partial conversion, early
forced conversion, and instruments that are not
redeemed when it appears best for the corporation
to do so. Any of these situations can arise naturally
from various contract incentives in the debentures.
Moreover, the contracts that cause such behavior
may not be associated directly with the convertible
debentures themselves.
A standard convertible bond can be exchanged
by its owner for a fixed number of shares of the
corporation’s stock. The conversion ratio is nor-
mally adjusted if the company splits shares or pays
a stock dividend. Convertible bonds are usually
unsecured debentures, and like other corporate
debt instruments, they are frequently callable and
have sinking-fund provisions. The call price, the
value at which the corporation can redeem the
whole bond issue with a brief delay, is generally
greater than par, although it sometimes declines to
par on a schedule specified in the indenture agree-
ment. In addition, some convertible bonds contain
a put prescribing that the issuer redeem the deben-
tures at a fixed price. In summary, then, the conver-
sion and redemption features of convertible bond
contracts create complex options for both issuers
and owners. These options can create incentives for
strategic games by different parties to a contract.
Feasible Conversion Ratios. A numerical
example illustrates the alternative conditions for
pricing convertible debentures. As previously, the
market value of the corporation is V. The corpora-
tion’s market value of equity is E, convertible deben-
ture value is C, and the value of other senior bonds
(if the company has other bonds outstanding) is B.
Equity value E is divided among n shares. The con-
vertible debentures, convertible for m shares over-
all, have an implied exercise share price of
V–B
k = -------------- .
n+m
May/June 2004
Bond Games
The fully diluted share exercise value, k, is the price
per share if all the convertible debentures are exer-
cised for stock at the same time. If the fully diluted
share market price exceeds k, the debentures are in
the money. The conversion ratio for a debenture
into stock is x, so m/x is the number of convertible
debentures. In addition, for this example, each con-
vertible bond is callable for a fixed call price, Q(t),
which can vary through time.
To illustrate how conversion ratios affect
debenture prices, consider a company that has a
combined market value of V = $1 billion with aggre-
gate share value E = $450 million divided among n =
25 million shares, each with a share price of $18. The
convertible issue is 5 million debentures, each of
which trades for $110 per instrument. Par value of a
convertible debenture is $100. The company has no
other bonds, so B is zero (for now). Given that inter-
est rates do not cause a premium, the minimum
value of a convertible debenture is its stock value if
converted immediately. Therefore, the minimum
value is at least $110 = 18x. Solving for x gives 6 1/9
shares as the maximum conversion ratio for the
debenture with price $110 when the stock is worth
$18 per share. The usually computed conversion
price is $100/x = $16.3636, which does not account
for dilution (see Brealey and Myers 1991, p. 542).
Some convertible debentures, however, state the
conversion option in terms of a fixed conversion
price rather than a ratio. In this case, the fixed price
would be at most, given the debenture value of $110,
$18.00 per share.
At a conversion ratio of 6 1/9 shares per deben-
ture, the stock value of one debenture is $110 if
converted. With m = 5,000,000x, or 30,555,555.56
shares overall, and B = 0, the stock value of each
bond if all debentures are converted is
V – B-
k = -------------
m+n
1,000,000,000
= -------------------------------------------------------------------
-
30,555,555.56 + 25,000,000
= $18.
Thus, a conversion ratio of 6 1/9 shares per
debenture and a debenture price of $110 are consis-
tent with a share price of $18 per share for this
corporation if the option value of the bond is zero.
Moreover, at this conversion ratio and stock
price, shareholders are indifferent about debenture
conversion because the stock price remains the
same whether or not the bonds are converted. Any
higher conversion ratio is inconsistent with a $110
price per debenture. For example, at a conversion
ratio of 6 1/8 shares per debenture, the conversion
value of a debenture is
59
Financial Analysts Journal
V – B - = $110.11236,
---------------------
( n + m )x
so each debenture is worth more converted than
held. At conversion ratios below 6 1/9 shares per
debenture, a price of $110 indicates a “live” option
value in the debenture, so conversion is not opti-
mal. In general, a conversion option is worth more
alive than dead.
Except for call policy, standard option analy-
sis of convertible debenture value deals with
bondholders’ problems alone (see Ingersoll 1977b,
p. 464). Issuers should call convertible issues just
as they become in the money, fully diluted, and no
longer call protected.10 Bondholders’ optimal
exercise strategy leads to conversion in four situ-
ations. For in-the-money instruments, conversion
should occur at maturity, at call, at an increase in
the exercise price as allowed in the indenture
(because conversion terms become less favorable
in the contract), and when dividend payments on
the stock commanded through conversion exceed
the debenture coupon. Instruments that are out of
the money should not be converted. In these cir-
cumstances, all bondholders act the same way:
They convert or they wait.
Emanuel (1983) and Constantinides (1984)
showed that bondholders may select other, more
complex strategies, however, to increase bond
value. These strategies depend on anticipated dilu-
tion through conversion and the distribution of
convertible ownership. Briefly, it may be optimal
for bondholders to convert an issue gradually if
they can act in concert. Thus, the market for con-
vertible debentures may invite a game element in
which the issuer is a passive player but the creditors
must somehow coordinate their conversions.
The game element in actual convertible deben-
ture markets is different. The corporation is a posi-
tive player in the conversion game. It can defeat the
bondholders to seize option value for its sharehold-
ers, although it is subject to limits determined by the
ownership control of the corporation in a dynamic
setting, the actions available to bondholders to
coordinate their activities, and the game’s effect on
the company’s reputation. Reputation determines
future debt indentures, freedom of action, and the
value of other current and future claims.
Redemption and Conversion. The example
just described sets the stage for an analysis of
redemption and conversion options. The convert-
ible debentures in the example with an exchange
ratio below 6 1/9 shares per bond have a conver-
sion option value impounded in the $110 debenture
price. Consider debentures with a conversion ratio
60
of 6 1/10 shares per instrument. The share price is
$18, and the convertible price is $110. As before in
the example, suppose the company’s only debt
issue is the convertible instruments, so B = 0.
In this situation, the conventional conversion
price per share is ($100/6.10) or $16.3534 and the
fully diluted conversion price is [from V/(n + m)]
$18.018. In a conventional sense then, the deben-
tures are way in the money. But the bondholders
will not convert because the conversion value, fully
diluted, is only $109.91 (6.10 × $18.018) whereas the
debenture value is $110. Thus, no bondholder is
tempted to convert, and for shareholders to buy and
convert instruments is also not economical. The
shareholders would like to have the debentures
convert, however, because upon conversion, the
share price would appreciate to $18.018 per share.
In such a case, the redemption features of con-
vertible debentures can benefit shareholders. If the
convertible debentures are subject to sinking at
either a market purchase price of $110 or “lottery
call” below $110, the corporation’s management
can benefit the shareholders with a purchase for
sinking-fund redemption or lottery call of the
amount scheduled to be sunk. In a lottery call, a
fraction of the bonds are called by random choice
of the trustee. The corporation need not substitute
other debt or equity for the convertibles sunk
because the bondholders take stock for their deben-
tures by converting when the lottery-designated
debentures are identified. In a purchase, the com-
pany must secure financing for the purchase. If a
“doubling option” (twice the normal sinking-fund
redemption) exists in the debenture covenant, it
also can be exercised, leading to a partial conver-
sion if a lottery call is used at a price below $110 and
a redemption if debentures are purchased at $110.
The following example shows how a sinking-
fund redemption works. Suppose the debentures
are no longer sinking-fund protected and 20 per-
cent of the convertibles are scheduled for redemp-
tion. The company can purchase at the market price
or redeem the instruments for, say, $105 through a
lottery call. Because the current debenture price is
$110 per bond, the corporation will attempt to
redeem (and finance) 1 million debentures at a
price of $105. If bondholders do not convert upon
notice of redemption, the total debt value of the
company becomes
(4,000,000 × $110) + (1,000,000 × $105) = $545,000,000
and the share value becomes
$1,000,000,000 – $545,000,000 = $455,000,000.
This share value is divided among 25 million
shares, which gives a share price of $18.20 for a
$0.20 gain on each share.
©2004, AIMR®

If the bondholders convert upon notice of
redemption and the remaining debentures stay at
$110, the company’s debt value is $440,000,000 and
its equity value is $560,000,000, divided among the
25,000,000 old shares and 6,100,000 new shares. The
result is a share price of $18.0064, which is
$109.8390 per debenture, or $4.8390 greater than
the $105 redemption price. Thus, the notified debt-
holders should convert if they can and the company
need not finance the redemption. The result is that
a partial voluntary conversion results from the
sinking-fund lottery redemption.
A similar analysis applies to a complete call.
If the convertible debentures can be called at a
price of $110 or less, they should be called to
benefit the existing shareholders. The convertible
debentures may be call protected, however, in
which case they can trade at Q(t), the call price at
time t, or higher. Naturally, once the call protection
ceases, convertible instruments should not trade
above the current call price of Q(t). Timely call was
documented for most of a sample of convertible
debentures by Asquith.
A simple calculation of conversion value and
call price is not sufficient, however, to predict a
forced conversion or redemption. In the example
given here, two factors could prevent a forced con-
version through a call when the call protection
interval has expired. First, to call the convertible
instruments, a credible method for financing the
call, unless conversion is assured, must be secured
by the corporation. Given a replacement-debt
financing cost of perhaps 1–2 percent of the issue
size, the transaction cost alone can explain a slight
premium over the call price.
Second, a more significant threat to corporate
control is a call delay. Consider the convertible
debenture issue used in the example. If the instru-
ments are convertible at an exchange ratio of 6 1/10
shares per debenture, the owners of the convertibles
are due 30,500,000 shares of stock in total—
compared with the 25,000,000 shares of stock other-
wise outstanding to shareholders. If ownership of
the convertible debentures is concentrated among a
few coordinated investors, a forced conversion
through call may change the share ownership struc-
ture in such a way that corporate control shifts to a
group outside the existing owners. Of course, if the
number of shares commanded by the convertible
debentures is small relative to the amount of stock
outstanding or if the ownership of the debt is dif-
fuse, control is not an issue that concerns manage-
ment.11 Nevertheless, the potential for convertible
instruments to be used as a backdoor to control is
one reason for delayed redemption through call.
May/June 2004
Bond Games
Exchanges, Indentures, and the Corporate
Claim Structure. A “control transaction” involv-
ing convertible debt introduces into the analysis
factors outside the simple conversion, call, and
sinking-fund features of a convertible debenture
issue itself. The example shows that a call can be
delayed, and sinking-fund acceleration eschewed,
if the potential for a change in corporate control
through redemption is an issue.
This aspect leads to another puzzle concerning
convertible debt. A company can force conversion,
even during a call-protected period, through an
exchange offer to the shareholders. The potential
for this type of transaction can influence the value
of a convertible instrument unless some other fac-
tor precludes the exchange. The puzzle is that such
exchange offers appear to be quite rare. Issues of
control may be the answer, although indenture
provisions can also limit such transactions.
Return to the example once again. Suppose, as
previously, that the stock price is $18 per share, the
debentures convert at 6 1/10 shares per instrument,
and the convertible debentures trade at $110 each.
Thus, the shareholders desire conversion but the
bondholders do not. Assume also that the deben-
tures are not sinking-fund instruments and that
they are either call protected or trading below the
call price. In either case, the corporation cannot
simply redeem the debt to increase share value. The
company can, however, execute a debt-for-equity
swap with the shareholders to extract for them
some of the convertible debt value even though the
convertible instruments are apparently redemp-
tion proof.
An exchange works by allowing existing
shareholders to swap their shares for new debt. In
the process, shares are paid a premium in new-debt
value for making the exchange. For example, sup-
pose the illustrative company proposes to issue
$300 million of new debt to exchange for 15 million
old shares at an exchange value of $20 per share—
which constitutes an exchange-based special divi-
dend (Constantinides, p. 390). With the $300 mil-
lion new debt, the remaining $700 million of firm
value is split between the remaining old shares and
the existing convertible debentures. The fully
diluted share value of the company, based on 10
million remaining old shares and the full conver-
sion claim from convertible debt of (6.1 × 5,000,000)
= 30,500,000 potential new shares, is
V – B- = 700,000,000
------------- ------------------------------
n+m 40,500,000
= $17.284 per share.
61
Financial Analysts Journal
The immediate conversion value of a convertible
debenture, if its shares do not qualify for exchange,
becomes (6.1 × $17.284) = $105.432. This dollar
amount is the new lower bound for convertible
debt value. The upper bound is less than $110
because the debenture’s claim on stock has been
reduced in value. Thus, upon notice of the
exchange offer, the convertible debt suffers a loss in
value. Because the exchange is a zero-sum game,
this loss exactly equals the gain in value realized by
shareholders.
If shares obtained by convertible bondholders
through conversion qualify for the exchange, the
conversion value of debentures is much higher.
First, suppose the convertible debentures do not
qualify for exchange. The maximum value of an
average share that reflects the weighted exchange
value plus full dilution value is
⎛ 15 ⎞ ⎛ 10 ⎞ make bondholders whole in the event of such an
⎜ ------ × $20⎟ + ⎜ ------ × $17.284⎟ = $18.9136,
⎝ 25 ⎠ ⎝ 25 ⎠ exchange offer. To circumvent this requirement,
or for 25,000,000 shares, $472,840,000. In other
words, $22,840,000 in value has been extracted
from the convertible bondholders, which equals
$4.568 per debenture. Thus, the minimum debt
value, the one if all debentures convert, is $105.432.
But if conversion shares do qualify for
exchange, average share value at best is
⎛ 15 ⎞ ⎛ 40.5 ⎞ instrument for stock—accomplishes the forced
⎜ ---------- × $20⎟ + ⎜ ---------- × $17.284⎟ = $18.018.
⎝ 55.5 ⎠ ⎝ 55.5 ⎠
The total value to shareholders is only $450,000,
which means that the minimum debenture value is
$109.91.
Several factors can limit a corporation’s ability
to do such exchange offers. First, the indenture
agreement for the convertible instruments may
preclude such a transaction. Second, the indenture
agreements of debt previously issued by the cor-
poration may preclude any type of exchange offer.
Third, such transactions can cause control prob-
lems. In the given example, old shares numbered
only 10,000,000 after the exchange whereas the
new shares issued for conversion equaled
30,500,000. Thus, if ownership of convertible debt
is concentrated, the new majority owners may take
a dim view of the corporation’s board and its man-
agers’ financial stewardship of their interests.
Finally, reputation effects can be important. Any
company that executes such an exchange is likely
to find very restrictive covenants in future debt
issues or a lower market price for debentures with
standard features.12
If the exchange offer is designed to force con-
version, the result of the exchange offer is a reduc-
tion in the company’s indebtedness from $450
62
million to $300 million. As a result, although at first
the exchange offer appears to increase indebted-
ness, it has the opposite effect because convertible
debentures convert into stock. In addition, because
convertible debentures without exchange protec-
tion are potentially exposed to such games, the
market value of such debt should be less than the
price computed strictly from its option features.
The forced conversion for the bondholders is sim-
ply a subgame in multiperiod pricing equilibrium.
To the extent that it is anticipated, it affects the debt
value from the first day and every day subse-
quently. So, to value a convertible debenture, its
features other than its obvious conversion ratio
must be analyzed.
Because an exchange offer for shares with
bonds can take option value from convertible debt,
indenture contracts for convertible issues usually
mandate an adjustment in the conversion terms to
the corporation can use a sequential game strat-
egy. First, the company proffers a replacement
convertible instrument to the bondholders in an
exchange in which the new debentures do not
prevent self-tenders to shareholders. If this freeze-
out works, the self-tender can follow. In this case,
two transactions—one to replace existing deben-
tures and another to exchange another type of
conversion. Of course, the freeze-out announce-
ment will cause bondholders to anticipate the
eventual stock exchange offer, which should at
once collapse the convertible debt’s value. More-
over, because bondholders can anticipate the
eventual sequence of transactions when the con-
vertible debentures are initially issued, the full
option value of the bonds should not be realized
during their life until conversion at maturity (see
Parrino 1997). The degree to which debt value is
affected depends on the issuing corporation’s rep-
utation and the reputation’s projected usefulness
to the corporation.
This game is a high-level game, one in which a
company might build its reputation for years to
cash in occasionally for a particularly valuable
transaction. One way to avoid or limit such games
is to cap the stock price in the convertible bond.
That is, the company commits to redeem the debt
at a fixed price if its share price reaches a specified
level. A recent convertible issue by Amazon.com
has this feature.13
Structured Trades and Convertible
Debenture Corners. A structured transaction
like the one outlined in the previous section can be
used to coordinate the actions of convertible debt
©2004, AIMR®

owners and to seize option value from the issuing
corporation. Because most convertible debentures
are also sinking-fund instruments, two potential
sources of value can be captured in a structured
position that consolidates all or almost all of one
issue. First, the standard benefit of a sinking-fund
option can accrue to the corner. Second, coordina-
tion of conversions in redemptions can create addi-
tional value. In short, when a single entity or
coordinated group owns all or almost all of a con-
vertible debenture issue, forced exchange or
redemption games that an issuing corporation
might play are nullified. In addition, the coordina-
tion of conversions during redemptions can
remove the chance of panic conversions and
increase the value of an SPE’s position.14
A setup parallel to a sinking-fund corner
shows how a structured convertible debt transac-
tion can be executed. Consider the convertible issue
used in the previous examples: 5 million deben-
tures with a par value of $100, a conversion ratio of
6.1 shares per debenture, and a redemption price of
$105 for sinking-fund lottery purchases. Suppose
also that the debentures have a 10-year maturity
and 2 percent coupon, with 5 years of (both call and
sinking-fund) redemption protection. If one SPE
owns the whole issue, it can issue its own collater-
alized serial notes in six tranches keyed to the
sinking-fund schedule and final maturity. Thus,
the original issue can be parsed into temporal slices
or serials. The derivative notes have maturities of
5, 6, 7, 8, 9, and 10 years. Each tranche has 1 million
notes with par values in the first four serials of $105
and a coupon of 1.9 percent. The par value for the
last tranche is $100 with a coupon of 2 percent. The
entity’s residual or equity tranche claims excess
interest and also incurs any tax implications of the
transaction because of discounts or premiums on
collateral purchases and derivative issues.
Redemption features also are structured into
the debenture tranches. Call is passed through with
a partial call (if allowed) that is allocated to short
tranches first. Each tranche can convert upon call
or maturity, but otherwise, no short-maturity
tranche can convert until the 10-year tranche does.
This provision solves the coordination problem
because holders of each tranche’s derivative note
must wait until redemption to convert unless the
collateral-issuing corporation changes its dividend
substantially or otherwise changes the collateral
redemption terms. The tranche with the highest
option value governs conversion. With all the col-
lateral notes held by the entity, derivative holders
are insulated from freeze-outs. Thus, an SPE with
derivative issues properly structured can solve
coordination problems among creditors. The effect
is to increase the SPE’s convertible collateral value
and the value of the SPE’s derivative instrument.
May/June 2004
Bond Games
Convertible debt once traded in an obscure
corner of the credit markets. These days, with
issues large and frequent, arbitrage between credit
and equity markets is a substantial business. A
large portion of newly issued convertibles is sold
directly to hedge funds. The funds sell issuers’
shares short to finance their convertible debenture
purchases. This practice works well when the cost
of the short hedge position, primarily dividends
and fees owed to stock lenders, is less than the
coupons earned on the debentures.
A second type of arbitrage trade, one directed
at two different types of investors, can be booked by
dealers acting as principals. Several large dealers
offer similar structured trades, which are swap-
based transactions, designed to strip the option from
the convertible debenture.15 A notional debenture,
minus the conversion option, is sold to a credit
investor as a callable corporate instrument with a
floating rate. The option on shares is sold to an
equity investor. If the share option is exercised, the
credit investor’s debenture position is called.
Although a similar structure to strip the option can
be established with an SPE, the swap combination
appears to make the trade most efficient if done as a
dealer-booked derivative issued by a creditworthy
dealer. Neither a hedge fund position nor a swap-
based strip, however, insulates a convertible deben-
ture investor from an issuer’s strategic manipulation
of debt value, unless the investors are few enough
to coordinate their own actions.
In summary, convertible debentures are com-
plex securities with many interesting features. The
most obvious contract conditions are the options in
the instruments—conversion, call, and sinking
fund. Other factors of the issuing corporation, how-
ever, can strongly influence value.16 These factors
include other covenants in the convertible debt
indenture, indenture restrictions in other debt issues
of the company, the concentration of convertible
debenture ownership and its potential for changing
the control structure of the company, and the repu-
tation of the corporation. Overall, this analysis sug-
gests that debentures that are not called when
calling would apparently be optimal, debt that is
called early, and debentures that convert when they
apparently should not would provide interesting
subjects for empirical research into corporate finan-
cial strategy.
Summary
For each new debt issue, a corporation that seeks
debt capital must weigh the costs and benefits of
various indenture contracts. Investors do the same.
In equilibrium, all parties are satisfied with the
63
Financial Analysts Journal
contract, an initial debt price is established for a
new issue, and capital is provided to the issuer
when the instruments are distributed.
As the issuing corporation’s fortunes rise and
fall after issue, the indenture agreement of one or
more of the company’s debt issues can become
restrictive in relation to the company’s opportuni-
ties and initiatives. In that case, the issuing corpo-
ration may wish to escape or modify the indenture
agreement. At the same time, the primary sale and
subsequent trading of a debt issue result in a distri-
bution of bondholders that makes various strate-
gies possible for both the corporation and its
creditors. Thus, depending on the circumstances, a
company can choose a negotiation, a defeasance, or
a game to change the nature of its indebtedness.
Negotiations are common for conventional
private placements, in which the distribution of the
debt instruments is limited to a small set of credi-
Notes
1. A number of papers have addressed topics related to the
corporate bond analysis developed here. In terms of direct
covenant provisions, Smith and Warner (1979) and Kalay
(1982) discussed corporate bond indentures and the poten-
tial for conflicts among different claimants. Black and Cox
(1976) and Ingersoll (1977a, 1977b) developed continuous-
time pricing models for perpetual debt instruments with
various redemption features. They showed with option-
pricing analyses how call and conversion aspects affect
bond values. Following Ingersoll (1977b), Asquith (1995)
showed that most callable convertible debt is redeemed by
corporations in a timely fashion. Conversely, King and
Mauer (2000) found that 86 percent of their sample of call-
able nonconvertible bonds were called well after the bond’s
market price exceeded its call price. Again, focusing on
convertible debentures, Constantinides (1984), Emanuel
(1983), and Constantinides and Rosenthal (1984) analyzed
optimal conversion strategies for owners of convertible
bonds. Regarding redemptions, Dunn and Spatt (1984) dis-
cussed sinking-fund games in an N-person Nash equilib-
rium framework. Dhillon, Noe, and Ramírez (2001) also
used game analysis to investigate simultaneous tender and
call offers for nonrefundable debt.
2. For some idea of the frequency of such actions, see Chatter-
jee, Dhillon, and Ramírez (1995). They constructed an initial
sample that contained all the companies that solicited bond-
holders to tender for cash or exchange existing debt for cash
and other securities from January 1989 through December
1992. This sample consisted of 157 cases. They then
restricted the sample to include only companies in financial
distress, which left 40 companies with 46 announcements of
tenders or exchanges in the time period. Of these 46
attempts, 16 were tender offers and 30 were exchange offers.
So, about one of these transactions initiated by an issuer
occurred each month. Of course, such actions happened
with private placements also, but none of these issues could
be included in the sample.
3. See Ruback (1988) for a parallel analysis involving the forced
exchange of stock with standard voting rights for a dual class
of stock with restricted voting rights but a higher dividend.
64
tors and secondary trading is minimal. Rule 144A
private placements are distributed more like public
issues and are usually exchanged for registered
instruments shortly after the initial issue.
In weighing redemption alternatives, the issu-
ing company’s managers must balance the benefits
of its reputation against its immediate requirements
for freedom of action. Moreover, arbitrageurs can
take positions to limit corporate options. The poten-
tial for these games between issuing corporations
and bondholders strongly affects debt values—
even before the games begin.
Erik Lie and the participants at the Frank Batten Young
Scholars Conference at the College of William and Mary
provided many useful comments. I also thank Gerald
Thunelius at the Dreyfus Corporation for helpful infor-
mation regarding convertible debentures.
4. An alternative tender mechanism makes the exchange effec-
tive only if two-thirds (or whatever portion is necessary for
an indenture modification) of the old bonds are tendered.
Although this mechanism avoids filling tenders when too
few bonds are tendered to effect the proposed change in the
old bond indenture, it also changes the game payoff by
reducing the incentive to tender. A new bond is not issued
(and protected) if most of the old bonds are not tendered.
5. The same sort of game can be played with existing share-
holders in a rights offering. A prisoner’s dilemma can be
constructed to force rights conversion even though share-
holders would be better off if rights were allowed to lapse.
6. In the LTV Corporation bankruptcy case in January 1990,
however, a New York court ruled that claims of nontender-
ing holders of old bonds would be valued at par in bank-
ruptcy whereas the claims of holders of new instruments
would be considered at market value. Because new claims
are generally issued at substantial discounts to par value,
the result was a reduction in the use of freeze-outs during
distressed restructurings (see Chatterjee et al., 1995). Qwest
built in the discount up front.
7. A few dispersed bondholders were not approached. Hence,
their sinking-fund bond holdings were not included in the
transaction.
8. Actually, in the deal illustrated, after the dealer bought the
collateral but before the transactions with the entity and the
sale of the derivative debentures to confirmed buyers
occurred, the issuing corporation bought its sinking-fund
bonds from the dealer for almost $129 million. The dealer
sold the zero-coupon Treasuries for about the purchase
price, yielding a dealer’s net profit after expenses of about
$4 million. The issuer replaced the sinking-fund bonds with
a private placement, so the whole transaction comprised an
efficient exchange of one bond issue with another without
a freeze-out. This approach suited all the parties.
9. Some convertible bonds have been issued that allow con-
version into a different company’s stock. For example,
Comcast Corporation sold two issues of complex convert-
ible instruments called “ZONES” in October and Novem-
ber 1999. These instruments are callable subordinated
debentures that can be exchanged, with some complica-
tions, for tracking shares of Sprint PCS issued by Sprint
©2004, AIMR®

Corporation. Comcast owned about 47.2 million shares of
Sprint PCS at the times the bonds were issued. The October
U.S. SEC 424B2 filing covered an issue of ZONES of $1
billion principal value, or 13,982,103 bonds, with a “green
shoe” clause (an underwriter’s call option) for another $150
million in principal value, or 2,097,315 bonds. These
ZONES have a principal value of $71.52 per bond. The
November filing was for ZONES of $571,427,500 principal
value, or 700 million bonds with a principal value of
$81.6325 per bond. A green shoe clause covered another
$85,714,000 in principal value, or 1,050,000 bonds. Each
issue allows a bond to be exchanged, subject to some con-
ditions, for 0.95 of one Sprint PCS share’s market value in
cash before bond maturity or a full share itself at maturity
in 2029. The bonds were underwritten by Salomon Smith
Barney, which then repurchased about $1 billion of the
ZONES from disgruntled customers in January 2000.
Salomon borrowed about 11 million Sprint PCS shares from
Comcast to hedge its position. See Sherer (2000) for a dis-
cussion of the repurchase trade.
10. Precisely, call is optimal when the value of the long-term
option impounded in the bond maximally exceeds the
value of the short-term option bondholders receive upon
call. The short-term option is usually 30 days.
11. Control concerns can also explain a company’s issuing
convertible debentures that convert into another com-
pany’s shares. Such issues usually occur when the issuer
holds a significant block of another company’s shares.
12. Parrino (1997) provided an example of forced wealth trans-
fer from bondholders to stockholders. Parrino also showed
that bondholders can anticipate the possibility of such
transfers (because the debt indentures are weak) by pricing
the bonds at a discount to other, similar bonds before the
transfer occurs.
13. The Amazon.com €690,000,000, 6 7/8 percent, 10-year-
maturity convertible issue in February 2000 has many fea-
tures that illustrate the potential for the games I describe.
The indenture explicitly provides that senior bond issues
can occur. To use such bonds in an exchange for shares,
however, requires a change in the indenture agreement, but
only a simple majority of principal value needs to vote in
favor of the indenture change in this particular issue. This
feature makes freeze-outs especially easy. These notes have
several other interesting features. The conversion ratio has
two reset dates—one year and two years after issue—at
which times the share price for conversion can be lowered
if Amazon’s stock trades down in price. Thus, the original
conversion ratio of 9.52862 shares can increase to a cap of
11.781 shares. The note issue is redeemable in whole or in
part at par with 30 days notice after 20 February 2003.
Conversion can follow the call. There is no sinking-fund
provision. Finally, the conversion option can be withdrawn
if Amazon’s stock price increases to 160 percent of its initial
conversion price of €104.947 to €167.915. If withdrawn,
Amazon must pay €206.25 to each note. In effect, Amazon
can exchange straight 6 7/8 percent notes for the convertible
notes with a simple cash payment. The terms of this cove-
nant mean that the notes’ value cannot exceed €1,600 per
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©2004, AIMR®