Intel holds up on hedged basis despite stock slide; Citigroup says convertible arbitrage paid off in February

By Kenneth Lim

Boston, March 3 - Intel Corp. convertible bonds stood up well on a hedged basis Friday against an early onslaught on the stock after the tech heavyweight cuts its revenue forecast on weaker-than-expected demand and shrinking market share.

"From an outright perspective, you may say that it's a little bit of a concern, but from a hedge perspective, to hear something like that would be a good thing because you're going to get volatility, and whenever you have volatility that's a good thing," said a buy-side trader.

The relatively new Amgen Inc. convertibles were also active on Friday. But with the two different tranches trading at similar levels, one analyst remarked that one of the two may be valued wrongly by the market.

Cephalon Inc.'s 2% convertibles due 2015 also traded up slightly in line with the stock, which one analyst said probably broke upwards on technical reasons.

Other names seen trading on Friday included Washington-based satellite radio broadcaster XM Satellite Radio Holdings Inc. Its 1.75% convertibles due 2009 were traded at 83.75 versus a stock of $21.875, said a sell-side analyst.

XM's New York-based rival Sirius Satellite Radio saw its 3.25% convertibles due 2011 trade at 118.375 against a $5.05 stock price.

XM stock (Nasdaq: XMSR) closed at $21.76, down 14 cents or 0.64%, while Sirius (Nasdaq: SIRI) ended at $5.01, down seven cents or 1.38%.

Madison, N.J.-based Wyeth's floating-rate convertible due 2024 - which currently has a coupon of 4.239% - changed hands at 107.75 versus a stock price of $49.75. Wyeth stock (NYSE: WYE) rose 18 cents, or 0.36%, to close at $49.88 on Friday. Wyeth is a biotech company with products in the pharmaceutical and consumer and animal health care sectors.

With February just over, research houses are also starting to weigh in on the state of the convertible market. A report by Citigroup said the market's outright year-to-date return of 3.8% was not much different from January, but investors who were willing to take a chance in the high-yield sector benefited more from narrowing spreads. The convertible arbitrage strategy also continued to give positive returns, the bank's convertible analysts said.

Merrill Lynch said U.S. convertibles' discounts to fair value shrank in February despite a drop in average implied volatility while European convertibles are now very equity sensitive and Asian valuations remain rich.

Intel steady on gloomy outlook

Intel Corp.'s 2.95% convertibles due 2035 were seen about 1.5 points lower on an outright basis early Friday after the chip maker lowered its forecast first-quarter revenue to between $8.7 billion and $9.1 billion, from $9.1 billion and $9.7 billion.

A sell-side source said the bonds traded at 88 points against a stock price of $20 in the morning. The securities were going at 89.5 bid, 89.825 offered versus a $20.80 stock the day before at another firm.

Intel stock (Nasdaq: INTC) fell to a low of $19.86 on Friday but climbed back to $20.32 by the end of the day, just 17 cents or 0.83% below Thursday's close.

A buy-side source said that on a valuation basis, the convertible actually "held up really well" and became a little richer on Friday, and any selling was probably in reaction to higher interest rates that affected the broader bond market.

"If people hedged had their rho [sensitivity to interest rates] hedged on Intel they would have done all right," the source said.

While outright investors in the convertibles may have been hit by the stock's early slide, hedge investors in the securities would have gained from the volatility sparked by the lowered guidance.

"With a name like Intel, what can you hope for but volatility - and you got it," the source said, adding that the company had "rock solid" credit.

Santa Clara, Calif.-based Intel said Friday it also expects gross margins to be cut by the lower revenue, but expenses would be lower on reduced spending. Analysts were already expecting that the company would miss expectations and was losing market share to rival Advanced Micro Devices Inc., which led one to note that investors had already priced in the negative outlook.

Amgen's bonds pique interest

The recently launched Amgen convertibles were active yesterday, said a sell-side source, with the 0.125% bonds due 2011 and the 0.375% convertibles due 2013 trading at 104.75 versus a stock price of $76.50.

The 0.375% securities are usually marked about 0.25 point higher than the 0.125% bonds, which led one sell-side convertible analyst to remark that "either the one-eighth is trading a little more expensive or the three-eighths is trading a little less cheap."

Calling both convertibles "volatility plays," he reckoned that the 0.375% securities were "quite attractive" at the reported prices on an implied volatility of 21.

The analyst said the biotech giant's underlying stock has been strong recently, but did not think Friday's interest in the name was linked to news earlier in the week that Amgen was seeking acquisitions as a strategy.

"It's not a surprise that they do strategic acquisitions, especially if the companies that they are moving into have promising phase 3 [drug trial] results, and so it makes sense for both of them [Amgen and the target company], and this way the company doesn't have to commit too much capital for the initial development."

Thousand Oaks, Calif.-based Amgen (Nasdaq: AMGN) saw its stock gain 22 cents, or 0.29%, to close at $76.69 on Friday.

Cephalon gains with stock

Another biotech name came into play yesterday, with Cephalon's 2% convertibles due 2015 gaining slightly in line with the stock. The bonds were seen trading at 185 versus a stock price of $81.75, and were marked by a major trading house at 186.33 bid, 186.7 offered against a stock price of $82.49 at the end of Friday.

A convertible analyst said the convertible was moving in line with the stock, which "had a great run." Friday's movement was likely because "the stock's breaking up on a technical basis," the analyst said.

Frazer, Pa.-based Cephalon is a pharmaceutical company.

Arbitrage profitable in February

The convertible arbitrage strategy gave cumulative returns of about 58 basis points in February, said Citigroup analysts Adrian K. Miller, Stuart P. Novick and Lynn S. Hambright in a research report Friday.

But the returns could be even stronger based on anecdotal evidence, said the analysts, who based their lower estimate on early results.

On an outright basis, the convertible market was largely unchanged from January, giving year-to-date returns of 3.8%, the team said. Preferred stocks were the worst-performing class of convertibles in February due to weakness at auto makers General Motors Corp. and Ford Motor Co.

Lower oil prices took their toll on energy-sector convertibles, which performed the worst in February, while the capital goods sector had the best return of the month and for the year to date.

Although "not much had changed since January," investors who took a chance and "happened to generate alpha" would have gained from the continued decline of corporate spreads, the analysts said.

"Assuming one's portfolio was set-up to take advantage of such a move, many convertible names in the high yield space witnessed spreads coming in 10bp - 15bp and some even more," they wrote. "Even risk premiums in the high grade corporate space saw spreads narrow approximately 2bp - 6bp."

U.S. discounts shrank: Merrill Lynch

The U.S. convertible market was richer in February in terms of discount to fair value despite a fall in average implied volatility, said a report by Merrill Lynch analysts Tatyana Hube, Jeremy Wyett and Girish Kumar.

Discounts in the U.S. market shrank even though implied volatility fell 0.7 point, to 24.8%, because call-implied volatility fell even steeper to 24.8%, down two points. Those two volatility measure are also very near the 90-day realized equity volatility for the underlying stocks, which rose 0.2 points, to 23.6%.

Meanwhile, convertible valuations in Europe are now driven by equity, the team said.

"We fail to find any real value in terms of implied volatility at these levels and hope we are not going to get a repeat of 2004," the report said.

In Asia, convertible bonds remain rich, despite some recent profit-taking by investors on possible anticipation of new issues.

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