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Koo-Koo Co-Co


A Co-Co is a contingent convertible bond, called such because it incorporates a covenant that requires a certain move up in stock price for the holder to have the ability to convert the bond into stock.

The use of the word "requires" in the covenants of the bonds is really just a clever gimmick (courtesy of the financial "engineers" on Wall Street) because mathematically it is necessary for the stock price to rise anyway for it to be economic for a holder to convert. But "requires" allows Wall Street securities lawyers to substantiate a position that a company issuing such a convertible would not have to account for dilution: since there was a possibility that the bond would never be converted, the company would not have to account for dilution of stock.

Companies loved to issue Co-Cos since they did not dilute the stock: almost all convertible bonds (85%) that have been issued over the last three years have been Co-Cos.

But recently the FASB has communicated that they see through the gimmick. Wall Street lawyers backed quickly off their stance: companies issuing Co-Cos would have to incorporate any possible dilution in accounting for stock outstanding.

Co-Co issuance has ceased and has caused convertible issuance in general to grind to a halt.

Two things are likely to happen now. First, convertible bond hedge funds have lost a primary source of profitability, the primary issuance of convertible bonds, and will consequently make less money. Second, secondary issues in the market should get a slight lift in price (basis) as money stops chasing new issues and chases the old ones, thus causing a temporary improvement in performance. This last point of course depends on whether new money will continue to come into these funds or go out; if it comes out, forget the second point.

So convertible bond hedge funds are in somewhat of a spot here. That is, until Wall Street comes up with another gimmick.
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