By Ronda Fears
Nashville, Jan. 14 - The price premium on Tyco International's new series B convertibles versus series A could widen by another 1 to 2 points, according to Deutsche Bank Securities Inc. convertible analysts.
"The A tranche initially appeared more attractive to investors, courtesy of the much shorter dated put and a higher bond floor. It traded as much as 1 point above the B tranche in the gray market," Deutsche analysts said in a report Tuesday.
"But subsequently this premium has been removed, and now it is the B tranche that commands a 1.125 point premium. Only ½ point of this reverse is attributable to the A's repricing."
The analysts said the B-over-A premium is justified because of Tyco's credit curve and the historical credit spread and stock volatility regression, which could also widen the premium provided Tyco doesn't hit any bumps in the next couple of months.
"Our hunch is that investors are not using the full credit curve to value the two tranches, thinking that the 5 year spread is likely to come down relative to the 12 year," the analysts said.
"Our conclusion is that unless TYC's 100 day volatility sags below 28%, the B tranche will continue to outperform even from its current 1.125 point premium. We estimate that the premium the Bs could trade at over the As to be as great as 2.84 points."
Initial gray market trading suggested that the market favored the A tranche with a put in year five over the B tranche with a put in year 12. Subsequently, however, the situation has completely reversed.
Using a 40% input stock volatility for both tranches, the implied credit spreads for Tyco's 2.75% series A convertible due 2018 trading at 105 is 275 basis points over Libor and for Tyco's 3.125% series B convertible due 2023 trading at 106.125 it is 248 bps over Libor.
An implied spread difference of only 27 bps suggests that the As may still be overvalued versus the Bs, the analysts said. But they argue that no real difference in input volatility is justified.
"At first we wondered whether it was justifiable to use the same 40% volatility input for both tranches," the analysts said.
"But there is simply not enough distance between the strikes and expected lives of the two bonds to justify a significantly different volatility input."
Tyco's credit curve for other pari passu senior bonds shows a much wider differential between the two curve points than the convertible market's assessment, an inversion of more like 90 basis points between five and 12 years, the analysts said.
Tyco five-year senior paper currently has an implied spread of 350 basis points over Libor, compared to the 12-year senior paper with an implied spread of 260 basis points over Libor.
Under those credit spreads and again 40% volatility, the theoretical value of the A tranche would be 103.28 and the B tranche 105.74.
"The key to why we believe that the B premium will remain, and may even increase, is based on the relationship between Tyco credit and stock volatility," the analysts said.
Research showed a very clear relationship between Tyco's credit spreads and stock volatility, the analysts note. In a regression analysis, the analysts said, the current credit curve inversion (10-year trading tighter than five-year) would not be removed until Tyco's 100-day volatility had come down to around 32%.
"With the current 100 day TYC having fallen to around 62%, the matrix suggests that the credit markets are already behind the curve, with values of L + 300 bps (5 year) and L + 216 bps (12 year) predicted by the regression," the analysts said.
"The key conclusion ... is that even as TYC stock volatility comes down, and the credit curve flattens, the B tranche still maintains its spread until the curve is completely flat at around 32% 100 day vol."
The analysts noted that they kept Tyco's stock price constant throughout the scenarios.
"Because we were primarily concerned with modeling how the two convertibles would perform in a situation where Tyco gradually hauls itself out of its capital structure mess, we deliberately focused on the scenario in which TYC stock goes nowhere and credit spreads and volatility gradually grind tighter," the analysts said.
"And in this scenario it seems that the TYC Bs still have room for outperformance."
But investors expecting another Tyco blow up should be holding the As, they added.
"Some investors will probably take a different tack, and will conclude that there are enough uncertainties remaining in the Tyco situation for the best strategy to owning the A tranche with 5 year default swap protection in the hope that Tyco blows up again," the analysts said.
"Although we wonder how likely this situation is, there is no question that anyone expecting renewed turmoil at Tyco will prefer the A Tranche (with CDS protection) over the Bs."
Tyco series A 2.75% convertible due 2018
| Ask: | 105.00
|
| Equity price: | $17.34
|
| Parity: | 76.11
|
| Premium: | 37.96%
|
| Yield to maturity: | 2.352%
|
| Current yield: | 2.62%
|
| Conversion ratio: | 43.892
|
| Conversion price: | $22.78
|
| Call: | Jan. 20, 2006
|
| Call price: | 101.1
|
| Implied spread: | L + 275 bps
|
| Put: | Jan. 15, 2008
|
| Put price: | 100
|
|
|
| Tyco series B 3.125% convertible due 2023
|
| Ask: | 106.125
|
| Equity price: | $17.34
|
| Parity: | 79.78
|
| Premium: | 33.02%
|
| Yield to maturity: | 2.726%
|
| Current yield: | 2.95%
|
| Conversion ratio: | 45.9821
|
| Conversion price: | $21.75
|
| Call: | Jan. 20, 2008
|
| Call price: | 101.82
|
| Implied spread: | L + 248 bps
|
| Put: | Jan. 15, 2015
|
| Put price: | 100
|
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