'Short-volatility' mandatories can be important part of convertibles portfolio: analyst Epstein

By Rebecca Melvin

New York, April 27 - Mandatory convertibles can be an important part of a convertible portfolio, according to a new research report from analyst David Epstein entitled "Getting more out of your short-term convertible paper."

Mandatories can be useful to a convert arb portfolio where the manager wants to lessen overall exposure to volatility. For the past several quarters, tightening credit spreads have offset the affects of compressing volatility, but convert arb portfolios are still long volatility in a more normalized environment, Epstein wrote in his report.

"Whereas most individual convertible positions are long volatility, most mandatories, especially those where the stock is near or below the lower threshold price, are actually short volatility; an increase in volatility increases the value of the implicit short call at the lower threshold price," Epstein said.

While mandatories introduce other risks, they can also often be set up on hedge with less credit risk and less capital at risk as compared to many convertible bonds.

Mandatories frequently richen when the underlying stock drops, which is beneficial to convert arb players and at least a cushion on the downside for long-only investors.

Mandatory issuers like Fresenius Finance Ltd., Great Plains Energy Inc., Hartford Financial Services Group and XL Capital Ltd. offer high current yields and would likely be bid up beyond "fair" value at some point, especially if the stock prices fell.

But mandatories that have already richened beyond "fair" value, especially because the securities have short lives and because mandatories are fairly easy to model, should be avoided or sold.

Archer-Daniels-Midland Co.'s $3.125 mandatory convertibles due June 1, 2011, at $40.09 on the convertible, versus $28.50 on the stock, is 3.8% rich, according to Kinex, Epstein said, which is "pretty significant" on both an absolute and annualized basis. Look to sell the mandatory or just swap into the stock if you are favorably inclined toward the stock.

Avery Denison Corp.'s $3.938 mandatory convertible due Nov. 15, 2011, with a recent level of $41.35 versus $39.09 on the stock, is 3.4% rich, and that is significant with only 6.5 months until maturity. Holders of the mandatory would be better off just selling, or swapping into the stock if they are very favorably inclined toward the stock, he said.

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