Citigroup, Bank of America drop on sector fears; Medtronic gains on deals; Nasdaq slips but recommended

By Kenneth Lim

Boston, Feb. 23 - Financials led the convertible market lower on an otherwise quiet day as fears of a prolonged recession and bank nationalization pushed underlying stock prices lower.

Citigroup Inc. and Bank of America Corp. fell outright and on a dollar-neutral basis despite attempts by the U.S. government to ease nationalization fears.

Wells Fargo & Co. gained outright, but gave up early gains in line with the stock.

Medtronic Inc. was a rare positive, improving after the company announced just over $1 billion of acquisitions to boost its heart valve business.

Investors stay away

Trading volumes were skimpy to begin the week as uncertainty about the economy and the financial sector kept investors at bay, market sources said.

"I thought today was just a very quiet day," a sellside convertible trader said.

A convertible analyst noted that financial paper form a significant portion of the outstanding convertible universe, especially the newer issues.

"Other than the fact that the health of the banks is closely tied to the health of the economy as a whole and to the credit markets, just the fact that there's still quite a bit of exposure out there and not a lot of clarity about what's going to happen, I'm not surprised nobody's doing much," the analyst said. "It's hard to know what's a good deal."

The outlook for the rest of the weak remained murky.

"It's tough to say," the trader said. "Everybody I talked to today was just waiting to see what happens."

Financials take hit

Financial preferreds gained in early trading but mostly ended in the red amid pessimism about the U.S. government's efforts to stabilize the major banks.

"They started off strongly on what read like positive news, for the preferreds at least, then they just have faded with the day," a convertible trader said. "Yuck."

Bank of America's 7.25% convertible preferred reached as high as 319 Monday morning, but fell to 247 outright to close 43 points lower. Bank of America common stock gained 3.17% or $0.12 to close at $3.91.

Bank of America is a Charlotte, N.C.-based bank holding company.

"Bank of America stock was up and the preferreds were down, so I would guess that it wasn't good if you were hedged," a buyside analyst said. "But I think they don't have much gamma so I don't think many people have it hedged."

Citigroup's 6.5% convertible preferreds fell 0.75 points to trade at 8 outright. The bank's common stock closed at $2.14, higher by 9.74% or $0.19.

Citigroup is a New York-based bank holding company.

Reports emerged Monday that Citigroup could be in talks with the U.S. government to take a bigger stake in the bank, possibly by converting some of the preferreds that were sold to the government into common shares.

Neither the bank nor the U.S. government have commented on those reports.

But the White House on Monday said the government continues to prefer keeping banks private, easing some fears of nationalization. But the market was not convinced.

"I'm not sure what else they can do," a sellside analyst said. "With the stock price as low as it is if they take more equity they're going to end up with a really big piece of Citigroup. They might not want to call it nationalization, but if it looks like it and it smells like it."

A convertible trader noted that Citigroup's preferreds were "actually getting close to its dividend."

The possible bargain, set against the risk of losing the investment if the bank were nationalized, was probably the decision before investors, the trader said.

"That's probably what some guys are doing, what's the downside versus what's my upside," the trader said. "That's probably what's bringing any buyers in. But you know, these preferreds, they whip around quite significantly in a single day. The headlines, it seems, they can move many points in a day."

Wells Fargo's 7.5% convertible preferreds did slightly better, ending up 34 points at 423.95 outright, although it was off its day's high of about 440. Wells Fargo common stock closed at $11.03, up by 1.1% or $0.12.

Medtronic shines

Medtronic offered one of the rare bright spots on Monday as its convertibles gained following the company's announcement of two acquisitions.

The Medtronic 1.5% convertible due 2011 was ½ point better at 94.25 bid, 94.75 offered versus a $34.19 stock price, while the 1.625% convertible due 2013 was seen at 89.75 bid, 90.125 offered against a $34 stock price.

Medtronic common stock was up slightly by 0.06% or $0.02 to close at $34.02.

"I think that was the only thing that was positive today," a buysider quipped.

Medtronic on Monday said it will buy two heart valve replacement makers for about $1.025 billion to strengthen its heart valve business.

The Minneapolis-based medical device maker will pay $700 million for Corevalve Inc. and $325 million for Ventor Technologies Ltd.

The deals were mostly seen as positive developments by the market, a sellside convertible analyst said.

"I think the general feeling is it's a good move from a strategic standpoint," the analyst said. "I don't think they've said how they'll fund these, but I don't expect it's going to be a problem. It's still a solid name, thank goodness."

Barclays recommends Nasdaq

Nasdaq OMX Group, Inc.'s 2.5% convertible due 2013 was marked lower on Monday despite a positive research note by Barclays Capital.

The convertible was marked at 70 against a stock price of $20. Nasdaq common stock fell 4.49% or $0.93 to close at $19.77.

"I think it's just down with the rest of the market," a convertible trader said.

The convertible is an attractive investment at the moment, Barclays analysts Manoj Shivdasani, Venu Krishna and William Gioielli wrote in a research note, citing sound company fundamentals and attractive risk-reward probabilities.

Nasdaq has a high-margin business with recurring cash flows that are only 40% driven by trading volumes, making the company a strong credit and more resilient than other financial companies in the current market downturn, the analysts wrote.

Using a conservative volatility of 40% and credit spread of Libor plus 750 basis points, the convertible should be worth about 77.5, the analysts wrote.

All types of convertible investors can use the note, the analysts added. The convertible could be a better investment than Nasdaq equity because of the favorable risk-reward profile for outright and equity investors, the analysts wrote.

Credit investors may find the 9.2% total yield attractive, and hedge the delta exposure by selling high implied volatility out-of-the-money call options or use out-of-the-money puts.

Convertible arbitrage investors should use a light hedge, the analysts wrote.

"Although we acknowledge the possibility of mark-to-market volatility, we are constructive on the name over a longer time horizon," the analysts wrote.

Mentioned in this article

Bank of America Corp. NYSE: BAC

Citigroup, Inc. NYSE: C

Medtronic, Inc. NYSE: MDT

Nasdaq OMX Group, Inc. Nasdaq: NDAQ

Wells Fargo & Co. NYSE: WFC

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