Convertibles spiral sharply lower on witch-hunt for accounting flags

By Ronda Fears

Nashville, Tenn., Jan. 29 - It was described as a witch-hunt - the search for any company with just a hint of accounting irregularities or complexities - which fueled a massive sell-off in stocks that virtually idled convertible trading. Tyco, one of many blow-ups, saw plenty of selling, though, and the converts fell 2.5 to 3.875 points on a 20% drop in the stock and a 200 basis point widening of the spread on its credit default swaps. Arbitrageurs were busy in stocks and derivatives, traders said, while outright convertible investors appeared to be rotating into cash.

Otherwise, the primary market was the source of convertible buying activity as investors lined up for the FPL Group mandatory deal after the close, and Acxiom Corp. added a notes deal for Thursday's roster. GATX Corp. and OSI Pharmaceuticals both priced deals that freed to trade Tuesday, and both were higher out of the gate.

"It was a crazy witch-hunt today," for any company with just a hint of accounting irregularities or complexities, said a market source. "Everything fell out of bed."

Yet, a convertible trader at a hedge fund in New Jersey brought the day's events into perspective, saying, "After Sept. 11, everything's relative," explaining that while he tries to do the best job he can, he goes home each day to where his priorities lie.

Accounting fears quickly erased all positive tone from economic reports that came in ahead of expectations and the Federal Reserve's seemingly steady stance on interest rates. Stocks began selling and in snowballed into a massive decline, with the Dow Jones Industrial Average losing 247.51, or 2.51%, to 9618.24 and the Nasdaq falling 50.92, or 2.62%, to 1892.99.

"It was panic selling in the stocks. There was not really a knee-jerk reaction in convertibles, although there was some selling and a lot of Tyco paper sold today. The dynamic arbs were adjusting their hedges, but for the most part people were holding onto their positions," said a convertible trader at a major investment bank in New York.

"Most of the selling was purely taking money out of the market. The rotation looks like it's into cash, because credit spreads were widening and so people were just going to hang on to their cash for another day. Of course, there are some new deals coming up, so some of it will likely be rolled back into the market on short order but as far as looking for bargains, no that wasn't happening."

In the biggest blow-up for the convertible universe, Tyco went underwater fast as concerns about the company paying $20 million to a director for his role in the CIT acquisition spooked the market. To no avail, the company confirmed the payment of a fee to Frank E. Walsh Jr., one of its outside directors, but said it was fully disclosed in a proxy statement filed Monday with the Securities and Exchange Commission.

"Clearly we are in an environment where people are intensely skeptical of corporate America, and for that matter, of Tyco. As we have said before, we are prepared to openly discuss whatever legitimate questions or concerns our shareholders, the analyst community or the media may have. We are extremely proud of the value we have built at Tyco and remain absolutely confident that, in time, this value will be recognized," said Tyco's chief executive. Dennis Kozlowski in a statement.

"Our businesses are healthy and continue to perform strongly. We are on track for the quarter and the year for earnings and cash flow. Our separation plan is moving forward in high gear. And we continue to believe, now more than ever, that it will create significant shareholder value. Obviously, we believe the reaction in our stock price is unjustified."

The wave of selling in Tyco was not stemmed in the least, however. The stock closed down $8.33, or nearly 20%, to $33.65. The Tyco zero-coupon convert due 2020 fell 3.875 points to 67.25 bid, 67.5 offered and the zero due 2021 dropped 2.5 to 69.75 bid, 70l.25 offered. The five-year credit default swaps on Tyco widened by about 200 basis points to 400 basis points, according to a derivatives trader.

"It was absolutely insane, the Tyco situation," said the derivatives trader. "The five-year swaps had come in by around 100 points last week on the breakup news, which was real, and today that was erased, and more. The thing that really can make you crazy with this is trying to make sense of it. You just take the orders, or whatever, and go on."

There were plenty of other disasters during the session, mostly notably affecting the convertibles of The Williams Cos. Inc. and Williams Communications Group as the market focused on the unit spin-off last year and Williams' remaining energy trading business after the company said it would delay its financial report and warned that it might not meet Wall Street's earnings expectations.

Williams' new 9% mandatory convertible fell 4.2 points to 21.32 bid, 21.45 offered as the stock lost $5.36, or 22%, to $18.78. Williams Communications' 6.75% convertible preferred dropped 2.28 to 10.25 with that stock off 29c, or 18%, to $1.34.

"It's beyond my capacity to understand what's going on," said a market source at a convertible boutique in New York. "The entire market's underwater and there's nowhere to hide. It's ugly. But, to some extent, our perceptions today I think are based on valuations that were out of line to begin with, especially in areas like telecom."

Buzz surrounding WorldCom and Qwest Communications as some point turned into talk of possible convertible deals from one or both of the names, but market sources almost unanimously dismissed the possibility of a new deal from either while their stocks are so depressed.

There was new paper in circulation, however. GATX's new 7.5% notes, which sold with a 16% initial conversion premium, soared to 107 bid, 107.5 offered. The par issue had traded at 105 in the gray market Monday. GATX common shares ended off 49c to $28.90. And, OSI Pharmaceuticals' new 4% notes, which sold at par with a 23.3% initial conversion premium, edged up to 100.875 bid, 101.125 offered with the stock down 98c to $39.57.

FPL Group was at bat after the close with a $500 million mandatory that priced with an 8.5% dividend and 18% initial conversion premium - at the middle of yield guidance and at the cheap end of the premium talk. There is about a 4% dividend on the common stock, which closed Tuesday down $2.99 to $52.56.

After the close, Gabelli announced it will sell $110 million of convertible Feline Prides, via Merrill Lynch & Co., this week, and Solutia comes to market Thursday with a small $100 million mandatory. The LaBranche & Co. Inc. mandatory has been put on next week's calendar.

Acxiom Corp. also launched a deal for Thursday's business. The $150 million of subordinated notes are talked to yield 3.75% to 4.25% with a 23% to 27% initial conversion premium. The seven-year issue will be non-callable for three years and have a put option in year five. The company is taking out a convertible and senior bond with the proceeds. The issue is about 4% cheap at the midpoint of guidance, analysts said, using a credit spread of 750 basis points over Treasuries and 45% volatility in the stock. The volatility is probably a little too low, one analyst said. The spread was justified by the credit default swap on Axciom's senior bond at 575 bps to 675 bps, plus the deleveraging that the convertible will accomplish.

In addition to the new paper heading north, there were a few remarkable gainers in the session.

Caremark Rx Inc. and Express Scripts Inc. got a dose of support from convertible investors after Merck & Co. Inc. announced the spin-off of its Merck-Medco pharmacy benefits management unit. Caremark's 7% convert was said to be up several points to 111.5 bid, 111.875 offered with the stock up 40c to $16.20. The Express Scripts convertible preferred gained 2.24 to 88.74 although the underlying stock dipped 65c to $45.45.

Xerox Corp. saw more gains on the heels of its surprise gain in fourth quarter results, with the new 7.5% convertible preferred up another 1.25 points to 75.25.

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