When Convertibles Don't Convert

Merrill Lynch today announced it was exiting the subprime mortgage origination market. Probably good news, right? At the same time it announced a modification of the terms of one of its existing convertibles. No discussion, no reason, just a modification. Probably bad news, but not for convertible holders.

The bad news is winning. The stock is down some 6%, plumbing new lows. Here's my attempt at why, for those with the stomach for dull technicalities.

The convertible securities are LYONs - "Liquid Yield Option Notes". A fancy name for an variable rate accreting nominal, puttable, callable zero coupon convertible bond. OK it's a fancy instrument too. In this case, the accretion rate is 3m LIBOR-2% and the conversion ratio is 14.0915 shares per bond.

What really counts, though, is that one of the put dates falls next Thursday, March 13, and Merrill don't want to run any risk of shelling out the $2.2bn redemption price. This is not "plan A" - these convertible bonds were supposed to turn into balance sheet equity at some point.

Today's sweetening amendments (i) increase the conversion ratio by 17% and (ii) add a couple of put dates in 2010 and 2014 (the maturity date is 2032). Merrill get nothing in return for these new features, they are unilaterally value-enhancing for the bonds. The bonds' fair value is now presumably sufficiently above next week's put strike that bondholders will not exercise. Cash call avoided, at least for now.

The increase in conversion ratio increases the delta of the bond, or its sensitivity to the stock price. The required additional delta hedging by convert arb funds, plus the inconvenient reminder that Merrill's balance sheet is stretched, is plenty enough to prompt the share price falls seen today.

John Thain may well have commented that "we will not have to go back to the market to raise capital". Unilaterally changing the terms of convertible bonds to avoid a redemption serves the same purpose.