Forest City Enterprises 3.625% convertibles due 2011 a good bet for hedgers, safer play than stock

By Evan Weinberger

New York, Nov. 28 - Between the collapse of subprime mortgages and plummeting home sales, the housing market has been the center of stock market volatility in recent months. According to Paul Berkman, the senior vice president for convertibles research at J. Giordano Securities, playing the hedge on Forest City Enterprises Inc.'s 3.625% convertible bonds due Oct. 15, 2011 is a solid way to harness the volatility.

The convertibles also provide protection against continued falls in the company's stock, said.

Forest City Enterprises is a Cleveland-based diversified real estate company that manages, acquires and develops malls, shopping centers, office properties, apartment buildings and planned communities. The company issued $287.5 million of convertible bonds in October 2006.

Forest City stock (NYSE: FCE-A) stock hit a high of over $72 in May but has since fallen steadily. The stock closed Tuesday at $47.60.

Along with the fall in price, Forest City's stock has seen a surge in volatility, Berkman noted, much like the rest of the sector. The current implied vol Berkman put on Forest City stock is 27, with 100-day vol standing at 35. At the beginning of the three-year period Berkman analyzed, the vol stood in the mid-teens.

"My expectation is that volatility in this sector is apt to remain high - and perhaps go even higher - until the economic outlook improves," Berkman wrote. "And I don't expect that to happen overnight."

Credit is not much of a concern with the convertibles, Berkman wrote. Debt makes up a little over 80% of Forest City's capital, with EBITDA covering interest expenses by about 1.4 times. Moody's has Forest City debt rated Ba3 while Standard & Poor's rates it BB-.

Forest City has two publicly traded straight bonds, one that matures in June 2015 and the other in February 2017 with credit spreads between about 350 basis points and 400 bps. The June 2015 bonds have a 7.9% yield while the February 2017 bonds yield 7.6%.

Using the other two bonds as background, Berkman put what he called a conservative 500 bps credit spread on the convertibles and came up with an investment value of about 85 and an implied vol of 23.5. The convertibles, Berkman wrote, merit no more than a 400 bps credit spread, however. Using a 350 bps spread, Berkman worked the convertibles to an investment value of 89 and an implied vol of 18.

The other attractive feature on the convertibles is their protection. They are non-callable for life and carry all the standard dividend and takeover protections. There is also a make-whole matrix for cash takeovers. Prior to July 15, 2011, the convertibles are putable for cash, or if Forest exercises the net share settlement option, cash and stock, subject to a 130% hurdle. After that date, they are putable at any time.

The conversion ratio is set at 15.0631. "So what we have here is, in effect, a noncallable bond, convertible into 15.0631 common shares, with contingent conversion feature until 6 months prior to maturity," Berkman wrote.

Overall, Berkman asserted that the theoretical delta for the convertibles appears to be around 65%. He said that his preference would be to round up to about a 65% hedge.

"Trading close to par, with a reasonably short maturity, and noncallable for life, the convertibles offer good gamma, so a neutral hedge can be quite profitable if the stock moves, even if the bond doesn't richen in terms of implied volatility," he wrote.

Even non-hedged investors should look to Forest City's convertibles if they want to try to make a play on the company, Berkman wrote. If Forest City stock trades higher, convertible holders will participate. If Forest City stock collapses, convertible holders will be protected. Stock holders won't he said.

"Clearly, the bond entails a lot less risk than the common," Berkman wrote. "These days especially, that's an important consideration."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.