Call threats intensify in convertibles as issuers cash in on low-cost refinancing

By Ronda Fears

Nashville, April 1 - Redemptions of convertibles are still catching holders off guard - even after a run of similar actions in recent months. The latest devastation occurred on Monday when Anadarko Petroleum Corp. announced a call.

Some say the call trap has caught holders in a tight spot because of the lack of product. Others point to a false sense of security setting in once a call date passes.

"For hedgers it [the Anadarko call] was quite significant, because it basically reinforced that issuers are looking to refinance wherever they can," said Jimmy Giordano, president of JGiordano Securities.

"Previously, under the right valuation, it was a good risk/reward, buying on the cusp [of the call price].

"In people's quest for yield, the older names have the nice, big, juicy coupons," he added, but those also are issues in which call protection is dwindling.

Add in the low cost of capital these days, and the likelihood of an issue getting called is rising.

"There may indeed be an issue of some convertibles being refinanced. Homeowners aren't the only borrowers who can refinance," said F. Barry Nelson, a convertible portfolio manager at Advent Capital Management.

"Personally, I've been surprised at how many over-leveraged companies are seemingly waiting for a better opportunity to refinance - a bold bet, in my view."

Anadarko is just one of the latest in a string of calls and among a group of several names that analysts have been exploring as call risks.

So why are holders getting caught in a squeeze? Many say it's for lack of anything else to buy. As a result, the market has been bid up and the risk is now beginning to bring on some pain.

"There's a real lack of product out there and people are pushing the envelope," said John Siebel, head of trading at Silverado Capital Management, a hedge fund based in New Jersey, who has avoided the call/put trap thus far.

Siebel did note that he is watching L-3 Communications Inc. closely, however, as the call protection on the 5.25s is rapidly diminishing.

"People are starting to get caught," Siebel said.

"It used to be, as a rule of thumb, you had a 10% cushion [on price related to call risk], now it's more like 1 or 2 points.

"They put on these issues thinking they will unwind when they richen," he explained, then suddenly the issue gets called and it's been trading above the call price.

"Some of the breakevens are beyond the maturity, which just blows your mind," Siebel said.

"It's bad enough when they're trading beyond the call."

With the Lipper experience as a backdrop, not to mention several research pieces from sellside analysts and recent redemptions, it is perhaps difficult to sympathize with anyone getting caught in a call/put squeeze.

Some onlookers also note, however, that not only is the excess capital in the convertible market driving players to reach for situations that are not necessarily smart but there also are some new players who perhaps aren't as savvy.

"Investors were generally factoring a bigger cushion before issues get called and that looks aggressive in retrospect, given that issuers have become more efficient in their calls," said Venu Krishna, head of U.S. convertible research at Lehman Brothers.

"This has to be put in historical context, given that in the past a fair share of calls were inefficiently exercised, working in the favor of investors," he added.

"Investors also assumed that issuers would be less likely to call zeros, given their non-cash interest expense and associated tax shield. While this is true generally, the current low interest rate environment is making refinancing attractive even in the case of zeros.

"On top of that, there is a massive trend towards deleveraging that is causing issuers to increasingly opt to either convert debt to equity or cash call it to lower absolute debt levels."

Also, there's the matter of the call date having passed without incident.

"In some cases, like Anadarko, the calls have materialized a little later than the first call date, causing the market to get lulled into factoring a bigger call cushion and then getting caught off-guard," Krishna said.

The Anadarko convert had been trading nearly 3 points over the call price, and it snapped back on the company's announcement to call the issue on Monday. The convertibles became callable on March 7.

There are some 75 convertibles callable in 2003. The vast majority are trading below the call prices, but there are a few that are trading above the call prices that could be susceptible.

Those include the Gilead Sciences Inc. 5% due 2007, Health Management Associates Inc. 0.25% due 2020, Johnson & Johnson (old Alza Corp.) 0% due 2020, L-3 Communications Inc. 5.25% due 2009, Lennar Corp. 0% due 2018, Nabors Industries Inc. 0% due 2020, Teva Pharmaceuticals Inc. 1.5% due 2005 and United Parcel Services Corp. 1.75% due 2007.

In some cases, the call overlaps with a put, such as D.R. Horton Inc.'s 0% due 2021. The homebuilder announced Monday that it would make a cash payment for any bonds put back to it on May 12.

While D.R. Horton did not make a bona fide call of the issue, the converts had been trading nearly 2 points above the call/put price and pulled back on the news.

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