Fed waylays markets on change in signals; Kodak bonds offered; power issues cooler but still hot

By Ronda Fears

Nashville, Jan. 28 - Nothing emerged in the way of a new deal in the wake of the Federal Reserve holding interest rates steady, as the surprise signal from the Fed that interest rate hikes may be sooner rather than later rocked the markets.

Convertibles were caught in the crossfire of a sharp selloff in bonds and heavy profit taking in stocks. Before the Fed headlines, though, it was a more upbeat market.

"Everybody kind of took it on the chin after the Fed," said a sellside convertible trader.

Yet, he added that most players had taken out some insurance in the way of interest rate hedging, so the damage was mitigated to some extent.

Still, he said, the shift in sentiment at the Fed was somewhat of a surprise.

Although the primary market remained quiet on the Fed news, or was quieted by the market reaction to it, a convertible pro said the fact that interest rates remain at historic lows - with the overnight Fed Funds rate at 1% - should bode well for issuance.

"If anything, there is a pressure on issuers to come to the market sooner than later to lock in the low coupons before the bond market sells off too much," the analyst said.

If not for the surprise, and severe reaction, a capital markets source said there likely would have been something surface from the shadows Wednesday. He agreed that the steady rate environment should be positive for issuance at least through first quarter.

The only inkling of a deal was a minuscule $50 million convertible perpetual preferred by LTC Properties Inc.

Fed headlines stall trading

Instead, there was havoc in the markets, and convertible trading slowed considerably in the afternoon after a moderate though choppy morning session. Before the headlines hit the tape, traders also said that convertible levels exhibited more equilibrium but were decidedly negative following the news.

"Most things were a little weaker, especially after Greenspan crashed the party by removing the 'considerable period' language from the Fed's policy of keeping rates low," said a convertible market source.

The Fed signal was subtle, despite the reactions to it. Removed in the Fed statement was the phrase "considerable period," which was replaced with a sentiment that the monetary policymakers "can be patient" about lifting key interest rates.

There has not been a rate hike since May 2000; the current Fed Funds rate is the lowest since 1958.

Analysts have been hounding convertible investors recently about taking precautions against rate risk, and sources said in general the market is well insulated.

The most rate-sensitive issues in the convertible universe are the busted, high-yield issues, or any that are at-the-money. Also affected by way of equity valuation are the Old World stocks, like Eastman Kodak Co., that have more bond-like cash flows.

Homebuilders, like Lennar Corp., were kicked twice Wednesday, first with the 5% decline in new home starts in December, then again by the signal that interest rates may be on the rise as that could curb construction.

Otherwise, convertible trading was "slack, [as] the sweet spots are few and far between," as one buyside trader put it.

"The [convertible] market is very efficient these days," said a senior convertible dealer at one of the bulge bracket firms.

"If there's a trade out there, some angle, then it gets hoovered up in a hurry.

"People are taking a view, picking a stock or a credit. You have to right now. There's no way to hedge out and sit back and make money."

Kodak picture fades

A signal from the Fed that may be prepping the markets for a rate hike sent shockwaves throughout the convertible market. In many cases, it was a matter of seizing an opportunity to lock in profits. Kodak fell into that category, traders said, as sellers emerged for the bonds, which had already begun to slide.

The Eastman Kodak Co. convertibles were offered Wednesday. On swap, with a delta neutral hedge, the 3.375% bonds came in about 0.375 points. In dollar points, with the stock down 76 cents, or 2.54%, to $29.13, the convert dropped 2.25 points to 119.75 bid, 120 offered.

"These bonds were well bid for on the day of the earnings and they have steadily weakened ever since," a dealer said.

Last Thursday, Kodak announced earnings and a new plan to cut costs up to $1 billion by 2007 by means of a 20% cut in its workforce, among other measures, all the while aiming to further reduce debt. That took the Kodak convertible up by about 1.25 points on swap, and in dollar points it added 8.5 points.

Builders get double whammy

To some extent, Lennar also suffered from profit taking. But traders said the slide in Lennar began some time back, more toward the end of 2003.

"People were nervous throughout the last half of 2003 about the rate of homebuilding, that it could not be sustained," said a convertible trader at a fund based in New York.

"Some people began getting out a month or so ago. They [Lennar] redeemed one of their convertibles, so if you had an offer you were probably looking to take it."

New home sales fell 5.1% in December but still hit a record in 2003 on an annual 11.5% gain. Existing-home sales, which surged almost 7% in December, also hit a record in 2003, as super low interest rates attracted buyers.

But, anxiety that the building spree may have reached its limit has brought out sellers for homebuilding paper.

Lennar's convertible dropped 4 to 5 points to 65.375 bid, 65.875 offered, the trader said.

The underlying stock plunged $2.92, or 6.24%, to $43.71.

Utilities, IPPs power up

Without any specific news, utility and independent power producer issues were roaring higher around midday. Included in the convertible market were Calpine Corp., Dynegy Inc., Reliant Resources Inc. and Sierra Pacific Resources Corp.

"This sector is on fire right now," a dealer said, right at about noon.

Then, the Fed took the winds out of the sails, as these high-yield names are hurt badly in a rising interest rate environment.

Yet, the trader said behind recent strong gains in the group are rising energy prices - electricity, natural gas, oil and heating oil - along with the winding down of the so-called Enron Corp. fallout, which has overshadowed the sector since the fall of 2001, and wrapping up settlements with regard to the California power crisis of 2000 and 2001.

"I think all these will bounce back; the sector is just too hot right now," the trader said.

Calpine's new 4.75% convertible had been around 5 points better but closed nearer to unchanged at 115.75 bid, 116 offered. The stock ended up 5 cents, or 0.9%, to $5.59.

Dynegy's 4.75% convertible wound up losing 1.25 points to 152.625 bid, 153.625 offered, but the trader said it was up as much as 2.25 points earlier Wednesday. The stock closed off 6 cents, or 1.19%, to $4.97.

Reliant's 5% convertible settled out with a 0.625-point gain at 120.875 bid, 121.375 offered. The stock closed up 13 cents, or 1.66%, to %7.98. Reliant reports earnings Thursday before the market open, and a conference call is scheduled for 9 a.m. ET.

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