Salomon analysts recommend Fiat/GM exchangeable on cheapness

By Ronda Fears

Nashville, Tenn., May 8 - The Fiat/General Motors exchangeable bond has exceptional investment merit for hedged and unhedged investors alike, said Schroder Salomon Smith Barney convertible analysts in a report Wednesday. The analysts noted risk that Fiat could be downgraded to junk status, however.

"On an implied volatility of under 20% we believe the Fiat/GM 3.25% exchangeable bond to be theoretically cheap," said London-based analysts Christopher Davenport and Natalie Archbold in the report.

"The premium falling below 10% enhances and makes more apparent the attractions of the security. One important implication of the premium being in single figures is that the vulnerability to any further deterioration in the Fiat credit is greatly reduced."

The implied volatility of the Fiat/GM 3.25% convertible has remained at about 20% since soon after it was issued in December and currently stands a little below this level at 17.7%.

The bond has performed poorly relative to the stock, however, as the credit spread for Fiat has widened, the analysts note.

In mid-December, parity was 68.5 and the convertible stood at 97.25. Now parity has risen to 93.47 but the convertible has clawed its way up only to 102.25.

"These developments have changed the complexion of the convertible," the analysts said.

"With the premium down to single figures, the equity characteristics of the bond now predominate. Delta has risen from 38% at issue to 62% now, on our calculations."

The impression that this is fundamentally a high 20s volatility stock is supported by observation of the traded option market, the analysts said, noting that January 2004 $70 calls trade on an implied volatility of about 28%.

Also, the analysts note, the combination of credit deterioration and premium contraction has given the Fiat/GM bond interesting characteristics of credit sensitivity.

"If the Fiat credit continues to widen, the impact on the bond will not be severe, in our view, since the premium is already so low," the analysts said.

"On the other hand if the credit spread were to tighten, the convertible would be expected to benefit considerably."

The analysts use a credit spread of Libor plus 400 basis points, or Treasuries plus 459 basis points. If this were to widen to Libor plus 650 basis points, the expected response of the convertible would be a 2.3% fall, the analysts said, whereas if the spread were to narrow to Libor plus 150 basis points, the convertible would be expected to go up 3.1%.

Compared to the GM issued convertibles, the Fiat/GM exchangeable is a better buy, the analysts added.

Using a Treasuries plus 290 basis points credit spread assumption to value the GM 4.5% 2032 and GM 5.25% 2032 convertibles, on this basis the implied volatilities are 26% and 23%, respectively, the bonds appear fairly valued but expensive in relation to the Fiat/GM exchangeable.

There is risk that Fiat's ratings could be downgraded to below investment-grade, the analysts noted.

In a report dated May 1, Schroder Salomon Smith Barney fixed-income credit research analysts reviewed recent events and considered the probable reaction of the rating agencies.

"The report reiterated our view that Fiat is a low-BBB credit with negative outlook, in spite of the distinct possibility that the company will fall below investment grade status with either S&P or Moody's," the analysts said.

On April 24, S&P put Fiat's A-3 short-term ratings under watch negative to reflect the "company's persisting poor financial performance and uncertainties regarding its ability to reduce debt-leverage from current aggressive levels."

Given that A-3 is at the bottom of the short-term investment-grade scale, this means that S&P is considering taking Fiat to high yield. S&P indicated that it would conclude the review by mid-May.

"We think there is a very high chance that ratings will be lowered as S&P's analysis is based on long-term prospects for the issuer and not on short-term liquidity," the analysts said.

Moody's placed Fiat's Baa2 long-term ratings on review for downgrade on Feb. 27 because the agency wanted to verify whether the company would be able to implement its restructuring and complete planned asset sales to reduce debt. The review was meant to be speedy but as of April 30 there has been no resolution.

"We think there is a 20% chance that Moody's will lower Fiat to high yield," the analysts said.

There also appear to be three other major issues, the analysts said, noting potential concern about the underlying shares not being "ring-fenced," uncompensated dilution and that converting bondholders sacrifice accrued interest.

With regard to ring fencing, the analysts noted it is common for European exchangeable bonds to not obligate the issuer to set aside the exchange stock in an escrow or equivalent account. As it is, however, holders can convert at any time, obtaining parity, they note.

"The concern seems to be that if bankruptcy descended so quickly that bondholders were unable to exercise their rights of conversion in time, they would be left as unsecured creditors," the analysts said.

"This seems a highly remote possibility and, in our view, does little to justify the bond's discount valuation."

As for dilution, the analysts said the prospectus wording for compensation for the dilution involved in the payment of a special dividend is also unexceptional. General Motors shares currently yield about 3.2% and total annual distributions in excess of 7% are treated as special dividends.

"In theory, the company can therefore make a material increase to the dividend without compensating bondholders," the analysts said.

"Our view is that this is not a major issue. The chances of GM paying a special or greatly enhanced dividend are not great - no greater in fact than the chance of the pay-out being reduced. Interestingly, even if one took as a certainty that a one-off special payment of 3.8% would be paid, the impact on fair value would be only 2.5 bond points and the impact on implied volatility about 4 percentage points."

On the matter of accrued interest, the analysts noted that interest is seldom payable on conversion in European convertibles and their valuation takes this feature into account.

Fiat $2.2 billion 3.25% due 2007

Conversion Ratio: 1.438

Convertible Price: 102.25

GM Share Price: $ 65.00

Parity: 93.47

Conversion Premium: 9.39%

Yield-to-Maturity: 2.73%

Investment Value: 91.21

Spread: 459 basis points over Treasury

Moody's Rating: Baa2

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