Calpine new issue trade seen awkward; Dobson off on buy; PMA Capital exchange seen

By Ronda Fears

Nashville, Sept. 24 - Calpine Corp.'s proposed new convertible was a major focal point for the market Friday as players tried to get a grip on the specific mechanics of the trade. Otherwise, secondary action was again described as having a softer tone, although there were "a few bids showing up."

Wyeth's convertible floater, for example, was active and showing a slight gain at 99 bid, 99.25 offered following a bullish credit report from the Citigroup fixed-income group, plus the appeal of floaters in a rising interest rate climate. Convertible floaters of Sallie Mae, Bristol-Myers Squibb Co. and Bausch & Lomb also edged up on trades Friday.

Airline issues were the most high-profile losers of the session, as crude oil futures hit another all-time high of $48.88. Despite all the major carriers boosting airfares in response to higher fuel prices, the paper fell across the board by around 1 to 2 points.

Dobson Communications Corp.'s convertible preferred was quoted at 45 bid, 52 offered, which a sellside dealer said was off 3 to 5 points from Thursday after the phone company said it had made an offer to buy some cellular assets for $26 million using funds from its bank facility.

More emerged on the PMA Capital Corp. situation and what apparently moved its 4.25% convertible up 5 points on Thursday. A market source said that while nothing is formal, apparently "the company has sent out an informational notice to holders of the issue requesting information (as to QIB status) in the event of an exchange for the existing issue.

"There's no offer [from PMA Capital] currently on the table, but apparently the market is convinced that there will be one and the terms will boost the value of the existing converts," the source said. "I'd guess that they'll lower the conversion price and possibly boost the coupon in exchange for a longer maturity."

Calpine's deal piqued interest from a broad mix of potential buyers, sources said, but many said there was a great deal of "skepticism" about the specifics of trading the new convertible as well as the company's general outlook.

It was pointed out by one fund manager who sat in on the Calpine conference call Friday morning that, considering the $600 million convertible appears to be cheap at least on the surface as Calpine has pledged nearly every bit of available security it has for the proposed $785 million straight junk bonds, it seems that "Calpine is determined to get the High Tides off the balance sheet one way or another."

But, he added, "since it is not really a debt reduction but an increase in net debt, the company's business plan comes into question and that is not a compelling argument to buy Calpine paper."

Rather, he said, along with a sellside desk analyst, the pending Calpine deal makes the Mirant Corp. paper look very appealing.

Calpine borrow risk a stickler

Calpine's new convertible bonds look cheap on the surface - one sellside analyst estimated the discount issue worth 107 in a thumbnail workup - but buyside sources said the stock portion of the equation, particularly with regard to the stock borrow, throws a wrench in the model.

The 10-year convertible senior unsecured non-callable notes will be printed with a 6% coupon and are talked to price at 83.9 for a 7.15% yield. The notes are talked with an initial conversion premium of 40% to 45% or a premium of 17.5% to 21.7% at the discounted price. Through a stock loan agreement with Deutsche Bank Securities Inc., sole bookrunner of the convertible deal, the issue will effectively be sold on swap. Another sticking point in calculating fair value for the convert is that it will skip cash coupon payments in years three through five, when interest will accrete.

"It all depends on how the stock borrow works out," said a buyside analyst.

"Partially mitigating this risk is the stock borrow freed up after the company calls the two trust preferreds and buys the $266 million of 4.75s from Deutsche Bank. On the other hand, though, a lot of high yield funds buy deep discounted straight bonds and short stock against them. So, a lot of this 'extra,' non-Deutsche borrow may get used up by the high-yield guys against Calpine's longer-dated bonds.

"Thus, all in all, this unknown could make the bonds trade cheaper until the mechanics become cheaper."

An outright convertible fund manager was not impressed with the talk about the deal's cheapness, as he said, "Calpine will always trade cheap. Until there is some catalyst, probably a bad one at least for the equity, the deal shows you how they feel about their shareholders.

Calpine bonds' value clouded

A sellside analyst away from the Deutsche desk said the new Calpine convertible looks "very cheap, given a relatively low conversion premium and 10 years of call protection. We're coming out with a fair value of approximately 107, although our model is having trouble incorporating the on-again, off-again stream of cash coupons, so we may be a little off on the exact valuation."

He said the 107 theoretical value was based on a credit spread of 850 basis points over Treasuries and a 50% stock volatility.

Another sellside analyst, also away from Deutsche's convertible desk, took issue with the inputs, noting that the Calpine credit default swaps were quoted at 2,000 basis points over Libor just before the deal emerged. He added that the volatility in Calpine stock will probably be dampened by the new deal.

"The credit will tighten maybe to 1,800 to 1,500 basis points [over Libor] and a 50% vol would be okay now, but if the credit tightens that will pull it back," he said. "We're using a credit spread of 1,500 basis points and a 45% vol, which is probably aggressive but what a lot of people will use, and with a blended borrow cost of about 2%, we get it somewhere in the low 80s versus an issue price of 83.9."

Buyside onlookers say the divergence in valuations on the deal again underscores problems at Calpine and suggests there are no exuberant enthusiasts for the paper.

"Is it true that Calpine can only sell debt, while at the same time offer a borrow to short and in so doing facilitate better its potential demise [by] giving parachutes to guys who never believed in your stock away for free?" posed the outright fund manager. "If so, then why not issue more equity or make the bond even cheaper - with no borrow. Where are the brazen bulls in this equation?"

Trade mechanics questioned

The mechanics of the trade on the new Calpine convertible made it "less cheap, certainly," onlookers said, and the structure overall makes some skeptical.

"In a perfect world they are very cheap, but as I understand it, people will buy bonds from the underwriter and get a stock borrow for the bonds from them," said a convertible analyst at a hedge fund. "However, whether or not that borrow stays in place for a 'specific' buyer as the bonds trade around is another matter. Theoretically, the bonds will have to trade 'with the seller's borrow' for the trade to work for the buyer. Yet, not all back offices may be able to work this out depending on whom one clears through."

Cheapness speculation aside, some potential buyers are hesitant because of the bells and whistles in the transaction, including the fact that concurrent with the convertible offering, Calpine said it will use cash on hand to repurchase $266 million of its existing 4.75% convertibles from Deutsche Bank.

"It is all too nuanced and makes me suspicious, probably unwarrantedly so. It is the typical derivate type transaction and I need to get more focused on what the deal really is," said a convertible fund manager in California. "I thought Deutsche had a position in old bonds that they are helping the company retire using newly issued lower coupon priced bonds for replacing [the bank's] current long hedged bond position, and then trying to unload it on the hedge funds - a good trade for Deutsche, marginally good for Calpine, and maybe cheap enough for hedgies to take the risk off of Deutsche's books."

Calpine existing convertibles lower

With the convertible proceeds, Calpine said it would call its 5.75% High Tides I convertible preferreds and 5.5% High Tides II convertible preferreds, leaving only the 5% High Tides III outstanding. On the news all the issues traded up. But on Friday they all traded off slightly, albeit amidst far less volume than on the day the new deal emerged.

Convertible players had been widely anticipating Calpine to refinance the High Tides convertible preferreds, which altogether come to around $1 billion. The San Jose, Calif.-based independent power producer is selling $785 million of straight senior notes via bookrunner Merrill Lynch on Monday alongside the convertible.

The preferreds dropped about 0.125 to 0.5 point Friday.

Calpine's 4.75% convertible notes, however, dropped another 2 points to 73.5 bid, as Calpine shares lost 15 cents, or 4.37%, to close at $3.28.

Mirant couched against Calpine

Sources on the buyside and sellside of the convertible market mentioned that Calpine's new issue made them take a look at the Mirant convertibles, which have been seeing buyers push the paper higher sporadically over the past week.

"When you look at these new Calpines and then look at the Mirant issues it jumps out at you that the Mirant issues are a better investment," a sellside desk analyst said.

"The company has already hit bankruptcy. Now they are in the process of the turnaround, it is a better-managed company, etc."

A week ago, there were some rumors in the distressed debt market that there might be some progress in the Atlanta-based independent power producer's reorganization plan, but that never bore fruit. Still, traders said Friday that Mirant paper continues to "tick higher, little by little."

The 2.5% and 5.75% convertible bonds were described as about 1 to 1.25 points better Friday in the 63 area. The 8.3% and 8.5% straight bonds were seen in the high-80s, while Mirant's 2003 bank debt was seen as recently as last week in the low 60s.

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