(FORTUNE Magazine) – It was an irresistible proposition: Borrow billions of dollars, pay no interest, reap millions in tax breaks, and then wait for the debt to simply disappear. That was the promise of zero-coupon convertible bonds, and companies from Enron to Merrill Lynch binged on what seemed like free money.

But, of course, there was a catch: For this scenario to play out, a company's stock price had to rise sharply--and quickly. That's because investors bought the bonds in the hope of converting them into equity--if the stock tanked, the bonds would no longer be worth converting. So to make them more attractive to buyers, companies had to build in an escape hatch: If the stock price failed to rise sufficiently, investors could "put" (that is, sell) the bonds back to the company--in many cases, after just one year.

And that's exactly what's about to happen--to the tune of some $65 billion over the next three years. Stock prices have fallen so far that for at least half of these special hybrids, the prospect of conversion is now absurd. It simply won't happen. So bondholders are looking to get their money back the first chance they can. And because of the put feature, that is possible. Suddenly companies like Tyco, Comcast, and dozens more are on the hook for billions of dollars in debt and interest they thought they'd never have to pay.

That could be very bad news for shareholders of these companies. After all, they're the ones who are going to be picking up the tab when all that debt comes due. Huge chunks of cash will disappear from balance sheets to repay bondholders. Companies without enough cash--and the majority fall into this camp--are likely to face skyrocketing interest charges when they borrow money anew. That means sharply reduced earnings. Especially at risk are investors in companies with poor credit ratings--prime candidates for killer refinancing costs. Some companies may even be forced to issue stock to pay off the debt, creating significant shareholder dilution, especially at current depressed prices. To make matters worse, this is happening at a time when the economy is barreling downhill and corporate profits are already shrinking. "This is a ticking time bomb," warns Margaret Patel, manager of the Pioneer High Yield Bond fund, a top-performing junk fund.

The seeds of this mess were sown in mid-2000, when the stock market started to falter. Companies in search of capital balked at the thought of selling stock while their share prices were struggling. Zero-coupon convertible bonds presented an attractive alternative because companies didn't have to make cash interest payments on the bonds (hence the name "zero"). Instead issuers offered an up-front discount--for instance, investors would buy a bond for $700 and collect $1,000 when it matured.

Companies also gave investors the right to convert the bonds into a fixed number of common shares. But the bonds were structured so that conversion would make sense only if the stock price rose significantly--in many cases, by more than 50%. With that protective feature (called the conversion premium), zeros took off. Corporate issuers would pay no interest, and once their stock prices had climbed back to acceptable levels, the debt would be swept away into equity. "If the bonds are converted, it's a home run for everybody," says Jonathan Cohen, vice president of convertible-bond analysis at Deutsche Bank.

That four-bagger, of course, depends entirely on the stock price rising. If it doesn't, the bondholders, armed with that handy put feature, can simply sell the bonds back to the company. Great for bondholders, but not so hot for the company or its shareholders. But, hey, what are the odds of that happening? "CFOs and CEOs believe that their stock will just continue to go up," says Cohen. "They don't worry about the bond getting put."

If all this seems a little complicated, that's because it is. A real-life example should help. California-based electric utility Calpine issued $1 billion in zeros in April to refinance existing debt. At the time, the company's stock was trading at about $55 a share--severely undervalued in the opinion of company management. "We really didn't want to sell equity at that point," says Bob Kelly, Calpine's senior vice president of finance. So the company instead opted to sell zeros, setting the conversion premium at a hefty 37%.

Still, with no cash interest payments and a stock price that had to rise significantly to make conversion worthwhile, the bonds weren't exactly a screaming buy for investors. So Calpine added the put feature: Investors could sell the bonds back to the company after one year at the full purchase price, eliminating any downside risk.

Things haven't exactly worked out as management had hoped. The stock has since plummeted to $25, and it now has to triple before conversion makes sense. So it's looking as though Calpine will be liable for the $1 billion in borrowed money when investors get the chance to put the bonds this April. There's also the refinancing cost. According to Kelly, Calpine's borrowing rate could run in the neighborhood of 8.5%--an extra $85 million per year in cash. "Obviously, nobody plans for their stock to go down," Kelly says. "I don't think there was one person around who thought the bond would be put."

Calpine's potential costs are particularly high because its credit rating is straddling junk. "If you are a borderline investment-grade company, a financing of this nature is not necessarily the most appropriate thing in the world," notes Anand Iyer, head of global convertible research at Morgan Stanley. The problem is, there are a slew of companies with far worse credit ratings out there: Jeff Seidel, Credit Suisse First Boston's head of convertible-bond research, estimates that about half of all zeros outstanding fall into the junk category. And others are at risk of having their ratings downgraded before the put date. Today, with junk yielding as much as 5 1/2 percentage points above bonds rated investment grade, refinancing can be a pricey proposition.

Contract manufacturer Solectron is one that could well get hit by the high price of junk. It has $845 million in zeros that it will probably have to buy back this January, and another $4.2 billion coming down the pike over the next couple of years. Because of slower-than-expected sales, the company was recently put on negative credit watch by three rating agencies. And if Solectron's credit is downgraded, the zeros would slide into junk status, a situation that could cost the company--and its shareholders--tens of millions of dollars in refinancing charges.

Refinancing isn't the only worrisome cost associated with these zeros. Companies pay hefty investment banking fees to sell their bonds--up to 3% of the amount raised. If the debt is sold back, many will have spent millions for what essentially amounted to a one-year loan. "They're getting bad advice," claims one banker who didn't want to be named. "Look at the fee the banker earned and look at the kind of financing risk the company got into."

As if those potential consequences were not scary enough, shareholders can also get whacked when the bonds are first issued. That's because some 40% are bought by hedge funds, which short the company's stock (sell borrowed shares with the intention of buying them back at a lower price) at the same time that they buy the bonds. If the stock goes down, the shorts make money from their position. If it goes up, they profit by converting the bond to stock. This hedging strategy almost always causes the stock to plummet, at least for a while. Grocery chain Supervalu, for example, recently lost 10% of its market cap the day it announced it was issuing $185 million in zeros.

Despite all the pitfalls, the love affair with such Pollyanna bonds continues, thanks in large part to the slick tax and accounting loopholes they provide. In fact, the hit on earnings per share can be the lowest of any form of financing. Even better, thanks to a wrinkle in the tax code, companies can rake in huge tax savings by deducting far more interest than they're actually paying. All they have to do is agree to pay small amounts of interest if certain conditions prevail. Verizon Communications, for instance, would pay 0.25% annual interest on its $3 billion in zero bonds if its stock price falls below 60% of the issue's conversion price. In the eyes of the IRS, oddly, that clause enables the company to take a yearly interest deduction, for tax purposes, of 7.5%--the same rate it pays on its regular debt. (Why? Trust us, you don't want to know.) That adds up to an annual deduction of more than $200 million, even if Verizon never shells out a dime in interest. Not surprisingly, more than half of the zeros issued in 2001 contain similar clauses. "It's an incredible deal for them," says Vadim Iosilevich, who runs a hedge fund at Alexandra Investment Management. "Not only are they raising cheap money, they're also doing tax arbitrage."

So despite the enormous risks to shareholders, companies continue to issue zeros at a steady clip: According to ConvertBond.com, seven new issues, totaling $3.5 billion, have been sold since Oct. 1 alone. "I think the power of the tax advantage is going to keep them around," says CSFB's Seidel. Call it greed or just blind optimism that the markets will recover quickly--it doesn't really matter. Either way, it's the shareholders who'll be left paying the bill.

FEEDBACK: jrevell@fortunemail.com