Selling grips convertibles; convertible arb names weaker; Transocean A's decline a point

By Rebecca Melvin

New York, May 7 - The convertibles market was "materially weaker" Friday, as selling pressure hit in earnest after an initial lull during Thursday's broader market panic, market participants said.

"Yesterday there was some selling, but not that much. Everyone was just sitting on their hands," a New York-based sellside analyst said. But then on Friday, "everyone came in and stuff started gapping down" and "we realized the pricing weakness."

On Thursday, the weaker broader markets were hit by a sudden spike lower in equities late in the session that dragged the Dow Jones Industrial Average down more than 900 points to 10,075 between 2 p.m. and 3 p.m. ET. But the Dow immediately retraced 445 points of that loss to settle lower by 347.80 points, or 3.2%, at 10,520.

On Friday, the Dow shed another 140 points, or 1.3%, to settle at 10.380; and the Nasdaq Stock Market fell by a larger 2.4%, or 54 points, to 2.265.

The cause of that sudden downward spiral Thursday was still uncertain on Friday although there were reports citing computer error related to high-speed trading.

Early reports said the cascade may have been initiated by Citigroup trades, but a Citigroup convertibles source said that neither his firm nor the Chicago Mercantile Exchange had found any abnormalities in Citi trades.

The common thread running through the convertibles trading session Friday was de-risking, a New York-based sellside analyst said.

However, "there was a lot of stuff that didn't trade," a second analyst said.

"Some of the financials didn't do great, and some of the high yield was down. The balanced, convertible arbitrage stuff was very weak. The only thing bid was the vol. stuff," the sellside analyst said.

Secondary weakens

Virgin Media Inc.'s convertibles dropped another couple of points with their underlying shares trading down 75 cents, or 4.6%, to $15.68 on Friday. The Virgin Media 6.5% convertibles due 2016 traded at 113 late in the day, after trading earlier at 115 versus a share price of $16.00. In recent weeks, the convertibles had nearly touched 130.

Ford Motor Co.'s new 4.25% convertible due 2016 traded at 138.5 versus a share price of $11.50, which is right about where the shares went out on Friday in heavy volume.

The Ford convertibles had been better than 150 versus a share price of $12.65 a month ago.

Some of the newer issues were also weaker in trade.

Lennar Corp., which priced $250 million of 2% convertibles April 26, traded at 95 versus a share price of $17.50.

MGM Mirage, which priced $1 billion of 4.25% convertibles on April 18, traded at 94 versus a share price of $13.25, compared to their debut in the secondary market at 103.5 versus a share price of $14.70.

The new Owens-Illinois Inc. 3% convertibles, which priced Monday night, traded at 96 versus a share price of $31.25.

The A series convertibles of Transocean Ltd., which has been trading heavily all week, were about a point weaker on Friday, with trading of that company's three convertible bonds seen largely as a function of the situation in the Gulf of Mexico, where oil is leaking from a damaged wellhead and threatening the environment, local economies and major shipping lanes.

Textron Inc. was actually better on swap compared with a 9% drop in its underlying shares.

Wait-and-see mode expected

After the convertible market put in a worse performance Friday than other markets, such as the investment-grade bond market, sources expected market players to move into a wait-and-see mode come Monday.

"I think it's going to be a mild wait-and-see mood, with not a lot of buyers or sellers, and people hoping things blow over in Europe," the sellsider said.

"No one is willing to add any risk assets right now," he added.

The fear factor driving convertibles trade on Friday led to indiscriminate selling, but not wholesale jettisoning of the market, sources said.

The CBOE volatility index spiked up to above 40, from levels in the upper teens at the beginning of the week. "It's pretty incredible," a sellsider said.

Short-dated high-yield paper had "held in" pretty well before Friday.

On a dollar-neutral basis, it wasn't bad the first few days of the week, but on Friday bonds were coming in on swap, sources said.

"It's a negative feedback loop. People want to see how Europe goes, and they're selling bonds if they see that it's going to be harder to refinance. It's pure panic," the sellsider said.

Encouraging U.S. economic data was unlikely to bring any comfort to market players until the situation in Greece resolves. The improved U.S. jobless claims report seen Friday was viewed simply as the "lagging indicator" that it is, and the thinking was that the labor market would be unable to withstand too much pressure from the European crisis going forward, if the end game is bad.

Textron improved

Textron's 4.5% convertible senior notes due 2013 traded at 170 versus a share price of $20.65 on Friday. Shares of the Providence, R.I.-based aircraft, defense and industrial company fell $2.12, or 9.4%, to $20.38 on Friday.

"Those have held up fine, and if you're hedged, they actually have improved," a sellside analyst said of the deep in-the-money convertibles.

The analyst said that the paper is trading at 12 points over parity and has a delta in the mid 90% range, so it's going to move with the stock, with points over parity remaining fairly constant.

"They are a vol. trade plus a catastrophe put," the sellsider said, explaining that with parity at 155, even if the stock moved down 30%, the bonds would move down to par.

"Fair value would be 118 with the stock at $11, and they'd probably trade at 115. On your delta, you'd make so much on your stock short, you'd make 10 points," the sellsider said.

Mentioned in this article:

Ford Motor Co. NYSE: F

Lennar Corp. NYSE: LEN

MGM Mirage NYSE: MGM

Owens-Illinois Inc. NYSE: OI

Textron Inc. NYSE: TXT

Transocean Ltd. NYSE: RIG

Virgin Media Inc. Nasdaq: VMED

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