Five Star shoots up on debut; American Express garners interest as reset nears; Red Hat falls on rumors

By Kenneth Lim

Boston, Oct. 13 - The convertible bond market had another dull session on Friday, with Five Star Quality Care Inc.'s newly priced 20-year paper getting the most looks despite relatively light volume.

"It's painfully quiet," a hedge fund convertible bond trader said.

The Five Star convertibles had a shining debut, gaining about 3 to 4 points on an outright and dollar-neutral basis after the offering was upsized.

American Express Co. continued to trade actively, hovering slightly above par as the stock flirted just below the convertible's conversion price.

Meanwhile, Red Hat Inc. fell outright in line with the stock after an analyst suggested that the company could be facing new competition.

Five Star shines on debut

Five Star's new 3.75% convertible senior unsecured note due 2026 traded more than 3 points above par on Friday after the deal was upsized.

The convertible traded at 103.5 against a stock price of $10.28, and went as high as 104. It was offered at par. Five Star stock (Amex: FVE) closed at $10.24, down by 0.97% or 10 cents.

Five Star priced the upsized $110 million deal on Thursday after the market closed. The offering arrived within talk, to yield 3.75% with an initial conversion premium of 25.73%. Price talk was for a coupon of 3.75% to 4.25% and an initial conversion premium of 22.5% to 27.5%.

The size of the deal was originally $80 million with an over-allotment option for a further $12 million. The greenshoe is now $16.5 million.

UBS was the bookrunner of the Rule 144A offering.

Five Star, a Newton, Mass.-based nursing home and senior living community operator, said the proceeds of the deal will be used for general purposes, including possible future acquisitions.

The deal opened higher right from the start, although trading was concentrated near the start of the session and at the end, a sellside convertible bond trader said.

"Very few guys are doing them," the sellsider said. "They were quoted 3.5 to 4.5 points right around the opening, and then offered at 104 later in the day...Not a lot of volume at all."

Despite the small size of the deal and the light volume, investors seemed pleased with the terms of the convertible.

"It models out relatively cheap, there's no dividend on the common," a hedge fund trader said. "It's a 4%, it's a better coupon than we've seen in a while...and there's decent volatility on the stock," a hedged fund trader said.

A buyside convertible bond trader said the deal could have worked for both outright and hedge investors.

"I think it's good for either one, because it's not that big a premium, so outright guys can take part as well," the trader said.

"It was about 3.5 points higher on a dollar-neutral basis," a buyside convertible bond trader said. "Reminds me of the good old days."

American Express stays active

American Express's 1.85% convertible due 2033 finished unchanged on Friday, but continued to see heavy trading as the stock continued to hover just shy of the conversion price.

The convertible, which is callable in December, traded at 103 against a stock price of $57.95. American Express stock (NYSE: AXP) gained 0.22% or 13 cents to close at $58.02.

American Express is a New York-based credit card company.

"We've seen them trade quite a bit, they keep quoting around the 102, 103 level," a buysider said.

The convertible is due for a remarketing reset on Dec. 1, 2006.

The convertible essentially becomes a short-dated straight debt instrument with a remarketed yield if the 10-day average closing stock price is below the conversion price of $61.49, Lehman Brothers analysts Venu Krishna and Devapriya Mallick wrote in a note. If the average closing stock price is equal to or exceeds the conversion price, the convertible remains outstanding as a zero-coupon convertible with a recalculated conversion ratio and an accreting yield of 1.85%, the analysts wrote.

The value of the convertible will climb significantly if American Express stock exceeds $60.49 on Dec. 1, the analysts wrote, but will be stuck at par if the stock trades below that.

"Therefore, we believe the proper way to assess the risk/reward profile of the AXP 1.85s is to probability weight any potential upside in the convert from the stock reaching a level above $60.49 by 12/1/06, relative to the probability weighted loss of 3 points should stock not reach $60.49," the analysts wrote.

Given that Dec. 1 will be a binary event for the convertible, the analysts reckoned that the paper can be valued as a par instrument plus a call option and a call spread, giving the convertible an estimated value of about 103.15.

"The AXP 1.85% convertible appears to be trading relatively in line with the listed options market," the analysts wrote.

The analysts noted that there is a risk that American Express will call the convertible in December, but such an outcome is unlikely. Because the convertible is a contingent payment debt instrument, American Express stands to be shielded from a substantial amount in taxes - $3.18 billion by the analysts' calculations - over the lifetime of the bond if they leave it alone. The analysts added that American Express stock price would have to be around $71.29 for American Express to avoid tax recapture if it calls the paper.

"The above mentioned tax shield estimates suggests to us that the company is likely to have a powerful incentive to keep the security outstanding," the analysts wrote. "At the same time, one cannot entirely rule out call risk given prior precedent of some CoPa converts being called - such as the surprise call of the FDC [First Data Corp.] 2% due 2008 converts back in 2004."

Unless investors see American Express stock making a meaningful move over the next six to seven weeks, the American Express convertible offers "limited value at current levels," the analysts concluded. But the significant upside should the stock trade above the conversion price and the limited downside "make the convert worthy of consideration when viewed in the context of a diversified portfolio."

Red Hat falls with stock

Red Hat's 0.5% convertible due 2024 fell about 4 points outright on Friday as the stock slid on reports of a possible competing product from Oracle Corp.

The convertible traded at 103 versus a stock price of $20.10. Red Hat stock (Nasdaq: RHAT) closed at $19.90, falling by 7.4% or $1.59.

"They were moving with the stock," a sellside convertible bond trader said. "I don't think the credit's got anything to do with it, it's pretty much in line."

Jefferies and Co. equity analyst Katherine Egbert cut her stock price target for Red Hat to $21 from $24, citing "independent checks" that suggest Oracle is close to introducing its own Linux products.

Raleigh, N.C.-based Red Hat develops and maintains open-source Linux software. Redwood City, Calif.-based Oracle is also a software developer.

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