Case Study
The Negative Coupon Bond

by Prof. Ian Giddy, New York University

Is Lending Money to Buffett a Privilege Worth Paying For?

The New York Times

May 22, 2002

WARREN E. BUFFETT wants to borrow up to $287.5 million, and he thinks he should pay a negative interest rate on the money. That is, he thinks the lenders should pay him money. And what do the lenders get in return, aside from negative cash flow? They receive the right to buy shares in Berkshire Hathaway at a premium over the current market price. That right will be good for five years, by which time, the lenders will hope, Berkshire stock will have risen enough to make the investment a good one

The offering is a private placement that was unveiled to institutional investors yesterday afternoon by Goldman, Sachs, which designed the structure. In its announcement, Berkshire Hathaway said it was "the first-ever negative-coupon security." It is being offered in a private placement only to institutional buyers. The exact pricing is expected to be disclosed today.

Under the proposal made to investors, Berkshire would pay perhaps 3 percent a year on the bonds it is issuing. But the investor would also receive a warrant allowing the purchase of Berkshire stock.

To keep the warrant alive, investors would have to pay a higher rate, perhaps 3.75 percent, at the same time Berkshire made the interest payments. The net effect would be that Berkshire would receive a negative interest rate.

•  The warrant is expected to be priced at about a 12.5 percent premium over Berkshire's current stock price. The deal was disclosed after the market closed yesterday, with Berkshire shares up $300, to $77,900, in New York Stock Exchange trading.

The bonds would have a five-year life, but the holder would have the right to sell them back to Berkshire for face value on each annual anniversary of the offering. That would be expected to happen if Berkshire stock were to fall sharply. If it did, Berkshire would have borrowed money at a negative rate for the intervening period.

On the other hand, if the warrants are eventually exercised, Berkshire will have sold stock at a premium over the current market price.

Berkshire said the new securities are called Squarz (pronounced squares) but did not say just what those letters stood for. Investment banks love to copyright such names because they cannot protect financial structures from imitators if they prove to be popular.

Berkshire said it planned to borrow $250 million under the deal, with an additional $37.5 million available to cover overallotments if the deal sells well.

While a negative interest rate breaks new ground, Berkshire is far from the first company to take advantage of the combination of low market interest rates and the extraordinary volatility of the stock market. That volatility increases the value of an option to buy a stock, and that added value can offset the interest that a company would otherwise pay to borrow.

A number of companies have borrowed money at zero percent while offering warrants to buy their stock at a 30 percent premium or more over the price that is current when the bonds are issued. Berkshire is offering a lower conversion premium, which is good for the buyer, while demanding in return an effective negative interest rate.

It is able to do that because it requires periodic payments for the warrant, whereas warrants are usually sold as part of the original deal and require no additional payments.

Copyright The New York Times

Berkshire Sells 1st Negative Coupon Paper


May 22, 2002

NEW YORK (Reuters) - Warren Buffett's Berkshire Hathaway Inc. said on Wednesday it sold $400 million of what it called the first securities with a negative interest rate, as investors showed a willingness to accept a loss now in the hope of buying Berkshire shares at a good price within five years.

The sale left investors in the curious position of paying interest to a man recently worth $35 billion.

``I don't think he needs the money,'' said Ted Southworth, who runs the $190 million Northern Income Equity Fund in Chicago.

Buffett, based in Omaha, Nebraska, said he approached Goldman Sachs & Co. to design the security, a stock-bond hybrid known as a ``SQUARZ'' -- pronounced ``squares'' -- and conduct the offering. Berkshire is a holding company whose insurance and reinsurance businesses provide Buffett money to invest.

``Despite the lack of precedent, a negative coupon security seemed possible in the present interest rate environment,'' said Buffett, Berkshire's chairman, in a statement.

Southworth did not buy Buffett's securities despite, or perhaps because of, Buffett's legendary reputation as an investor, which earned him the nickname ``The Oracle of Omaha.''

``Given that Warren Buffett is selling something, should I really be buying?'' Southworth asked.

Berkshire's five-year SQUARZ consisted of a senior note and a warrant to buy Berkshire (BRKa.N)(BRKb.N) Class ``A'' or ``B'' shares.

They carried an effective coupon of negative 0.75 percent and are convertible into Berkshire shares at a 15 percent premium over the ``A'' shares' at Tuesday closing price. Berkshire, which boosted its sale from $250 million, said it may sell $100 million more SQUARZ to meet demand.

Berkshire pays investors 3 percent on the note, while investors pay Berkshire 3.75 percent on the warrant.

``We're yield buyers, and this is the antithesis of that,'' said Marty Hollenbeck, who invests $400 million in convertibles for Cincinnati Financial Corp., and did not buy the SQUARZ

Berkshire's Class ``A'' shares, which have never split, closed Wednesday on the New York Stock Exchange at $75,900, down $2,000. The ``A'' shares have risen 12 percent in the last year. Berkshire's ``B'' shares closed at $2,520, down $60.


Berkshire said it will use net proceeds from the sale for general corporate purposes, including possible acquisitions, none of which have been announced.

Buffett built Berkshire through acquisitions since May 1965, when he took over what had been a sleepy textile firm that made jacket linings.

Berkshire now includes reinsurer General Re Corp., car insurer Geico Corp., ice cream purveyor International Dairy Queen Inc. and underwear maker Fruit of the Loom Ltd. Its shares are up more than 4,000-fold since Buffett took over.

Southworth said he listened to Buffett on a conference call on Tuesday and suggested the billionaire may have sold SQUARZ

to enhance Berkshire's position as an acquirer of companies.

``He may be advertising, here and overseas, for companies that might be for sale, and that he wants to position himself at the top of anyone's list,'' said Southworth. ``His attitude is that if he misses one buying opportunity, it's one too many.''

Analysts say Buffett may also have conducted the sale because selling negative-coupon convertibles, like selling the more common zero-coupon convertibles, can be tax efficient.

Jeremy Howard, head of U.S. convertible research at Deutsche Banc Alex. Brown, said Buffett probably didn't draw huge demand from traditional convertible investors or hedge funds, despite increasing the sale from $250 million.

``We're not aware of outright funds that bought this,'' he said. ``This is (also) one of the lowest volatility stocks you can find, and typically hedge funds like higher volatility stocks. That makes it more difficult for hedge funds to trade. It wasn't egregiously expensive, but it was overvalued.''

Berkshire cannot buy back the SQUARZ. Investors may sell them back to the company after one, two, three and four years.

Berkshire Hathaway is one of only eight companies rated ''triple-A'' by Moody's Investors Service and Standard & Poor's.

Copyright Reuters

Buffett's Negative-Interest Issues Sell Well


May 23, 2002

Warren E. Buffett's new negative-interest bonds sold rapidly yesterday, even after the size of the offering was increased to $400 million from $250 million, with a possible offering of another $100 million to cover overallotments.

The new Berkshire Hathaway securities, which were underwritten by Goldman, Sachs at the suggestion of Mr. Buffett, Berkshire's chairman and chief executive, pay 3 percent annual interest. But they are coupled with five-year warrants to buy Berkshire stock at $89,585, a 15 percent premium to Berkshire's stock price Tuesday of $77,900. To maintain the warrant, an investor is required to pay 3.75 percent each year. That provides a net negative rate of 0.75 percent.

The securities were sold only to institutional investors in a private placement, but Berkshire did not take any risk that the buyers would be unable to pay the future warrant premiums. Buyers paid $10,340 for each $10,000 bond, with the extra $340 going to pay for zero-coupon Treasuries that will pay the extra 0.75 percent each year.

Copyright The New York Times

1. Show, with a diagram, the components of this security.
2. Can the bond be separated from the warrant?
3. Can you value the bond part and the warrant part independently?
4. How would a hedge fund seek to arbitrage a bond like this one?

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