Merrill Lynch falls on new convertible debt terms

NEW YORK (Reuters) - Merrill Lynch & Co (MER.N: Quote, Profile, Research) changed the terms on Thursday of a large convertible bond issue, raising fears of a cash shortage and sending its shares down as much as 6.8 percent.

The Wall Street investment bank and brokerage said it increased the conversion rate on about $2.2 billion of "liquid yield option notes" to 16.5 shares per unit from 14.0915 shares. This can makes the debt more valuable to investors who convert it to common stock. The debt's price rose.

Zero-coupon convertible bonds such as Merrill's can provide issuers with cheap financing and allow investors to benefit if the issuers' shares rise. Convertible bonds are stock-bond hybrids that can be converted into company stock and whose fortunes are closely tied to the underlying stock price.

Brad Hintz, an analyst at Sanford C. Bernstein, wrote that Merrill sweetened the conversion terms so investors would not exercise their right beginning next week to sell the debt back to the company.

"The market is concerned that this action signals a liquidity problem," Hintz wrote. "We simply do not believe that this is the case."

He said Merrill ended 2007 with $112 billion of excess cash capital and has more than $100 billion of banking deposits, giving it "a cheap and stable funding base."

The analyst also said that increasing the conversion rate would boost the number of Merrill shares outstanding by just 5.3 million, or 0.5 percent of shares outstanding.

Hintz also noted that many investors who buy convertible debt sell the underlying stock short as a form of arbitrage. He said this may have contributed to Merrill's share price drop.

Merrill announced the new convertible terms one day after saying its First Franklin Financial Corp subprime mortgage unit will stop making home loans, resulting in a loss of 650 jobs.