UAL convertibles, other in-the-money paper could see premium expansion in down market: Epstein

By Rebecca Melvin

New York, May 26 - UAL Corp.'s 6% convertibles due 2029 and Valeant Pharmaceuticals International's 4% convertibles due 2013 are among a handful of in-the-money convertible names that, if set up on a full delta hedge, could see premiums expand substantially if their underlying stocks drop, analyst David Epstein wrote in the May 25 issue of Convertible and Credit Insight.

Saks Inc.'s 7.5% convertible bond due 2013, Whiting Petroleum Corp.'s $6.25 convertible perpetual preferred and Reinsurance Group of America Inc.'s $2.875 convertible preferred due 2050 are other names offering a low-cost way to insure against a steep drop in equity markets, Epstein wrote.

The bonds were culled for reasons having to do with the convertibles' features, rather than due to a bearish view on the stocks.

The in-the-money convertibles offer a yield advantage versus the common stock, a modest conversion premium, and an underlying stock that could see a drop in a crisis. Parity could fall well below par in a crisis situation.

The hedged positions may generate a good return on capital-at-risk, and the points premium should be factored in even if the convertibles don't offer significant gamma trading opportunities, Epstein wrote in the article.

Such positions require greater leverage than balance or busted convertibles to generate any meaningful static return, and admittedly, many managers are lowering or contemplating lowering leverage right now. But while there are risks of taking on additional leverage, proper leverage has to be determined at the position level rather than at the portfolio level, Epstein wrote.

In-the-money convertibles are less likely to suffer from significant cheapening because the price of the convertible should find a firm floor at parity since it could just be converted, albeit not instantaneously.

In the same way, Epstein said he isn't recommending contingent conversion convertibles such as Ford Motor Co.'s 4.25% convertibles and Teradyne Inc.'s 4.5% convertibles that might otherwise be interesting because theoretically there could be a situation in which the stocks drop and convertible holders couldn't convert their bonds to shares right away.

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