New "with warrants" convertibles are good for issuers and investors, Deutsche says

By Peter Heap

New York, May 5 - The latest innovation of "with warrants" convertibles is good for both issuers and investors, according to a new report from Deutsche Bank Securities Inc. convertibles analysts.

For issuers, the new structure offers a high conversion ratio and a low interest rate, wrote analysts Jeremy Howard, Jonathan Cohen and Robert Barron.

Meanwhile, investors receive a much higher upside participation rate than is initially apparent and a high gamma.

"Although some investors question the merit of new structures that cannot be readily modeled using 'off the shelf' technology, we believe that this innovation is a positive one for both investors and issuers," the analysts wrote.

Recent issuers to use the structure are Affiliated Managers Group, Mandalay Resort Group, Wells Fargo and Carnival Cruise Lines.

The analysts also point out that the "with warrants" name is misleading since the convertibles always trade as a single security and are not designed to achieve bond-plus-warrant accounting.

Instead, Howard, Cohen and Barron say the securities are better viewed as "variable conversion ratio convertibles" - convertibles with two possible conversion ratios.

For issuers, the variable ratio allows issuers to achieve a high conversion ratio with a low interest rate. Wells Fargo and AMG achieved sub-Libor financing - that three of the four issuers chose floating-rate structures is incidental, the analysts say - while Mandalay paid 75 basis points over Libor, an attractive rate for a BB+ rated company. For Carnival, the 1.75% cash coupon for the first five years and accretion at 1.75% per year after that compares favorably to its existing 2% cash pay convertible due 2021 and 0% due 2021 that accretes at 3.75%.

For the conversion premium, the Deutsche analysts contrast the 77.79% to 110.75% levels achieved on these four deals with Freeport-McMoran Copper & Gold's deal where the issuer had to pay a 7% coupon to achieve a 70% initial conversion premium.

With contingent conversion features, the "if converted" dilution is not reported until the stock rises "a huge distance," the analysts added, citing as an example the 150% increase needed on Wells Fargo's deal to trigger the change in reporting.

Contingent payment also allows issuers to deduct interest costs for tax purposes at the non-convertible cost of debt. On AMG's deal the interest expense for tax purposes is 5.62% versus the Libor minus 50 basis points of cash interest paid.

For investors, Howard, Cohen and Barron said the problem is that the structure has run ahead of the capabilities of most off-the-shelf modeling packages.

To reproduce the performance, the analysts say investors should look at a long position of a number of shares plus long a smaller number of call options.

The additional "warrant" component also has a delta and, because it is long dated, a rise in the stock price results in a "decent" increase in the "warrant" price.

As a result, the theoretical value of the convertible accelerates faster as the stock price rises than if the "warrants" are not included, the Deutsche analysts said.

With a more rapidly rising delta, the variable conversion rate convertibles also benefit from a higher gamma.

Looking at the U.S. convertible universe, the Deutsche analysts found that most high-gamma names have short puts.

Excluding these securities, the four variable ratio convertibles appear in the top 23 gammas, with Wells Fargo at second place, AMG at 16th, Carnival at 22nd and Mandalay at 23rd. But the analysts also cautioned that the Wells Fargo has an extra twist because of the conversion ratio cap.

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