Lehman finds options market signaling several converts have high dividend risk

By Ronda Fears

Nashville, July 11 - Dividend risk has been a burning concern in the convert market in recent weeks, especially given the valuation leak as the result of unexpected dividend initiations or increases.

Mandalay Resort Group and Freeport-McMoran Copper & Gold Inc. are two more recent examples that particularly shook the market.

The risk has been so pervasive that nearly all new issues of late have included some form of dividend protection to holders.

Lehman Brothers convertible analysts in January identified several converts at risk of a valuation squeeze in the event of a change in government policy, which has come to pass, and they have now looked at the options market for cues.

The new report finds several more converts at risk, using a put-call parity analysis based on signals from the options market. Also, the report points out that the value of all the convertibles identified with a high dividend risk could drop, some rather sharply, in the event of a 1-3% dividend increase.

"Investors have been pretty hard hit in some situations," as the result of the change in tax policy and the resultant boost or beginning of common dividends by some issuers, said Venu Krishna, head of U.S. convertible research, in a conference call he hosted Friday.

Market participants have thus far tended to use a set of fundamental parameters to identify companies that could potentially start paying dividends or raise existing dividends, he said in the report, noting that was the approach of Lehman's report at the beginning of the year.

"In this report, we have looked at the options market to identify convertible issuers where the options market is pricing a potential dividend change by issuers," he said.

Using the options market signals, converts at risk were those of Allergan, Amgen, General Mills, GlobalSantaFe, Interactive Corp. (including the two Deutsche Bank exchangeables), Merrill Lynch, Pride International, United Parcel Service and Xerox.

All those converts are trading above fair value in the event of a dividend increase of 1-3%, using the Lehman Brothers valuation model.

The Interactive issues, Xerox, one Allergan issue and two Pride issues could decline the most in value in the event of a dividend boost, under the Lehman analysis.

Specifically, those were the two Deutsche/Interactive floaters due 2022 and Interactive Corp. 1.99% due 2029, the Allergan 0% due 2022, the Pride 2.5% due 2008 and new 3.25% due 2033, and the new Xerox 6.25% due 2006.

Under a fundamental analysis, converts still showing high dividend risk were the Baxter International 7% due 2006, Franklin Resources 0% due 2031, Chubb 7% mandatory due 2005, Chubb 7% mandatory due 2006, First Data 2% due 2008, Heller Financial 7% mandatory due 2004, Hewlett-Packard 0% due 2017, Johnson & Johnson (Alza Corp.) 0% due 2020, Lehman Brothers floater due 2022, 3M Co. 0% due 2032 and Times Mirror 0% due 2017.

Krishna noted that several new issues lately have included dividend protection features, but he also noted that some convertible structures - namely REITs, exchangeables and Zones/Phones - have tended to include similar protection features.

REITs with dividend protection listed were the Glenborough Realty 7.75% perpetual preferred, Innkeepers USA Trust 8.625% perpetual preferred, St. Green Realty 8% preferred due April 2008 and Thornburg Mortgage 8.68% perpetual preferred.

Exchangeables with dividend protection listed were the Liberty Media 3.25% into Viacom, Liberty Media 3.5% into Motorola, Liberty Media 3.75% into Sprint PCS, Liberty Media 4% into Sprint PCS, Loews Corp. 3.125% into Diamond Offshore and Cox Communications 0.426% into Sprint PCS.

Zones/Phones issues with dividend protection listed were the Comcast 2% into Sprint PCS due October 2029, Comcast 2% into Sprint PCS due November 2029, Tribune Co. 2% into AOL Time Warner, CenterPoint Energy 2% into AOL Time Warner and Alliant Energy 2.5% into McLeod USA.

Recent new issues with dividend protection listed were the WebMD 1.75% due 2023, DoubleClick Inc. 0% due 2023, Halliburton 3.125% due 2023, Advanced Medical Optics 3.5% due 2023, General Motors 6.25% due 2033 and Crown Castle 4% due 2010.

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