Deutsche analysts say new convertible trends favor hedge players, at a cost

By Ronda Fears

Nashville, Feb. 19 - Deutsche Bank Securities Inc. analysts say new convertibles coming to market with structures designed to minimize stock dilution have some interesting trade angles, with potential profitability, but also some tricky quirks that require more ongoing scrutiny.

"In order to tempt more issuers into the U.S. convertible market, underwriters are increasingly focusing on structures that facilitate a higher real conversion price than traditional plain vanilla convertibles," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Wednesday.

"The combination of low stock prices and historically low interest rates encourages corporates with financing requirements to rely on short-term bank financing or the straight bond markets. This trend merely re-enforces the bubble in convertible demand, with the result that virtually all new convertible issues are bid up in the secondary market, almost regardless of whether they are priced attractively or not."

Basically, three types of convertibles are used to address the issuers' concerns about dilution: call-spread overlay convertibles, a very high premium at issue or a stock repurchase in conjunction with the convert - the call spread overlay being the most common.

Recent convertibles from Micron Technology, McData and Freeport-McMoran, and deals from Computer Associates and Navistar International in 2002, used the call-spread overlay structure to achieve a higher effective conversion price.

But Freeport-McMoran recently showed how a plain vanilla structure with a very high premium of 70% was also a viable alternative to getting a super-high conversion price.

Other convertible issuers, such as International Game Technology, addressed the stock dilution issue by using a portion of convertible issue proceeds to repurchase stock.

From a buyer's perspective, the analysts said the stock repurchase structure is the cleanest hedge of all if the convertible can be sold on swap by the underwriters. In this situation, there should be a reduction in downward pressure on the stock following the launch, as the issuer repurchases stock that would otherwise be dumped on the market by convert arbs.

The challenge in a high premium structure is from the increased importance of the credit component. Credit spread assumptions change the delta significantly, the analysts noted. The Freeport 7s, for example, at 450 basis points over Libor show a delta of 56%, but at 1,000 bps it climbs to about 69%.

"On the demand side, the high premium bond is probably less attractive to the majority of potential buyers," the analysts said.

"Although the theoretical delta of these structures is still surprisingly high, there is a lot more credit risk."

The analysts noted a sizable discount in the market on Freeport's 7% issue due 2011 due to the very high premium structure.

The call-spread overlay structure offers the most interest from a hedging perspective, the analysts said, but cautioned that call-spread convertibles should not be considered in isolation.

"Call spread convertibles offer better gamma trading potential and could be extremely interesting if the underwriter looks like getting pinned at the lower strike at call spread maturity," the analysts said.

"Convertible arbitrageurs should be very cognizant of where the stock price is as this situation evolves," they added, "as the interplay between convertible and option markets may well add an interesting extra dimension, not to mention a potentially profitable trading opportunity."

The way the underwriters hedge a call-spread overlay will have important consequences for the trading pattern of the stock and OTC/listed options in the days following the issue.

And the analysts said arbs should be prepared to pay a higher implied volatility for a call spread overlay convertible as the market's long gamma position at the conversion price is offset by a short gamma position at the same strike in the OTC/listed market. So the usual volatility dampening effect of convertible arbitrage is significantly reduced.

In looking at the Micron convert, the analysts said that as the call spread approaches its maturity on Jan. 29, 2008, the benefits of owning the convertible could become especially apparent.

"It is not surprising to see that the stock price reference for settlement of the call spread is a 20 trading day period. But even with this cushion, the short gamma position for the underwriters if the stock is anywhere close to $11.79 in January 2008 could be quite challenging for an issue of this size," the analysts said.

"If this situation develops, we would expect the underwriters to be aggressive buyers of the convertible as their only realistic gamma offset as delta hedging a short call position of this size could be costly. Clearly this is an advantageous position for convertible holders to be in, and should support a premium valuation if the stock is anywhere near this level in five years."

© 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.