Omnicom, AMG spiral on new CoCo rule possibility; EDS active on tighter credit

By Ronda Fears

Nashville, July 7 - Omnicom Group Inc., Affiliated Managers Group Inc. and General Motors Co. were mentioned specifically trading lower due to a potential new accounting rule related to contingent convertibles menacing the market. GM, as well as Ford Motor Co., however, also were driven lower as the automakers announced new incentives to boost flagging sales.

Secondary flow - feeling particularly "summerish" - was on the light side, so that was a relief, convertible traders said.

Moreover, many players were saying the recent softness in convertibles has created some buying opportunities, not the least of which in relation to the market's reaction to the possible new rule for CoCo converts. Par Pharmaceuticals Cos. Inc. and Watson Pharmaceuticals Inc. were both mentioned in that vein as well.

Electronic Data Systems Corp. bucked the backlash whipping through the technology sector in the wake of a flurry of earnings warnings and was getting some nice action as the "credit tightened dramatically in the last couple of weeks," a market source said. EDS' convertibles were flattish Wednesday with the 7.625% mandatory at 16.33 and the 3.875% bonds in the 95 area.

Severe warnings from Veritas Software Corp. and Conexant Systems Inc., compounded by a pre-open warning from PeopleSoft Inc., again were a blow to the technology sector; however, traders said software paper was "holding its own" as the underlying stocks continued to drift south.

In fact, many convertible arbitrage players were rejoicing at the situation in tech land, as it caused volatility to spike in those names. Overall market volatility also ticked slightly higher, with the Nasdaq market volatility index at 22.26.

CoCo buzz bombards market

A proposal pending that could make contingent convertible issuers account for the potential dilution in their earnings roiled the market, though enactment of the change may still be months away if it is in fact adopted.

"The amount of interest is unbelievable," said Venu Krishna, head of U.S. convertible research at Lehman Brothers. He and Lehman's tax and accounting analyst, Bob Willens, authored a report on the matter and hosted a conference call Wednesday. Lehman convertible analysts have been talking about the issue since last September, though.

Omnicom, AMG and GM were pounded lower by the development, among several others, and one market observer said GM stock was downgraded Wednesday specifically because of the potential dilution from the convertible.

"Those [Omnicom, AMG and GM] are the most blatant to be impacted' by the new CoCo rule being considered," a convertible dealer said. "But we're hearing from the accountant types that it's not a done deal, likely, but not a done deal yet. So to that extent this is premature."

CoCo restatements a wildcard

Another big question weighing on the convertible market is whether a new accounting rule would require issuers of existing CoCos to restate earnings.

There are lots of alternatives for issuers if a new rule comes down the regulatory pipeline, Krishna said. They could make an exchange for the CoCo convertibles to write out those features, make stock buybacks, and the like.

Regardless, he said fundamental believers in these issuers with CoCo convertibles, whether from a stock or credit standpoint, should take note that this is an accounting issue, so they should be buyers on the weakness.

One source noted that although it might be more practical to think the potential changes would be made going forward, language in a Wall Street Journal article inferred the rule could be retroactive.

While the new rule might be somewhat of a deterrent for new issues insofar as investment-grade issuers are concerned, most market watchers said the change would impact smaller companies to a greater degree.

"It's busted guys that aren't tremendously busted, such as PWR [Quanta Services Inc.], that will likely feel a little pain from it," said a market source on the West Coast. That, he added, could discourage others from using convertibles as a source of capital.

GM, Ford slide on incentives

General Motors also was feeling the impact of getting rocked as investors negatively reacted to new, additional sales incentives announced Wednesday. Ford also announced further sales incentives and joined the ride heading south.

GM raised its incentives to $5,000 on many sport utility vehicles following a 15% drop in June sales and Ford raised cash rebates on some of its vehicles by $1,000 after reporting an 11% drop in June sales.

Sales in SUVs are feared to drop even further as gasoline prices remain high, and many market players fear the incentives will do little to boost sales of gas-guzzlers. Earlier this month, GM reported a 19% drop in total utility vehicle sales for June. Ford reported that June sales for its Explorer fell 17.8% and Excursion sales dropped 10.7%, but Ford did not break out total SUV sales.

GM shares lost 33 cents on the day, or 0.74%, to $44.22. The GM convertibles were off slightly, as well, with heavy volume.

Ford stock closed unchanged at $14.96 and its 6.5% convertible preferred lost 0.21 point to 53.33.

Veritas softness cues interest

Warnings from the tech sector sparked some severe price drops, and for many believers it signaled a buying opportunity. Numerous downgrades to the stocks in that group also created heavy volume to the downside and some massive spikes in volatility.

"A lot of this is just noise," said one player. "We've seen a lot of volatility as a result, and this is exactly what we've been looking for, it gives the arbs a chance to adjust their deltas and maybe make some money."

Veritas Software's convertible bonds were off about 4 points with the shares losing nearly $10 on Tuesday, and again Wednesday some believers were pounding the table. The convertible was described as little changed Wednesday with the stock ending off 4 cents, or 0.24%, at $16.96 on continuing heavy volume.

"As far as convert holders are concerned, this should still be a situation that has little if anything to do with earnings and/or company fundamentals," one market observer said.

"VRTS has about $2.7 billion in cash and marketable securities, versus around $700 million in debt, including the converts. In my opinion, they could lose a lot of money for a long time and still pay off the bonds when they become putable in two years.

"That said, the issue shouldn't fall too much below par. The low to mid-90s, where the 0.25s are sitting right now, ought to be the floor on the issue. Investors should be willing to get a YTP [yield-to-put] of around 4% to 5% here, I think."

Convert arb returns slide again

Again, Merrill Lynch reports that its convertible hedge index was in negative territory, although shorting Treasuries would help matters. Most of the loss in June was blamed on secondary market cheapening, with lower volatility and rising yields making further negative contributions.

For June, the Merrill convertible hedge index was down 0.47% net of a 2% annual management and a 20% performance fee, bringing the year-to-date net return to a negative 0.47% before hedging out interest rates.

As Merrill analysts have said before, shorting sufficient two-year Treasuries to reduce duration is an effective hedge against rising yields. Year to date, the rho hedge would have returned a positive 1.41% compared to a loss of 1.37% on the hedge index from rising yields. Adding back the net 113 basis points - 141 basis points minus the 20% performance fee - would take the net return for the index to a positive 0.66% year to date.

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