Deutsche analysts find XL Capital put scenario potentially interesting

By Ronda Fears

Nashville, Tenn., Aug. 7 - XL Capital Ltd.'s convertibles offer enough profitable outcomes ahead of the upcoming put date to make them worth owning, according to Deutsche Bank Securities Inc. convertible analysts.

On Monday, XL Capital said it would pay the put on its 0% convertible due September 2021 in cash.

The significant rise in XL Capital stock on Tuesday to close at $69.18 has made the situation a little more complex, however, noted analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Wednesday.

"In the context of a difficult market with few relatively stable credit opportunities, we feel that there are enough profitable scenarios to make XL Capital [0% due September 2021] a position worth owning for the next month," the analysts said in the report.

First, there is still the possibility of a sweetener with the put a month away, the analysts said.

Second, the accretion rate reset, or contingent payment feature, gives the bond additional value at lower stock price levels if it is not put.

And, there is potential for gamma trading through the put date.

As of Tuesday's close, the XL Capital 0% due September 2021 was offered at 58.625 compared with the Sept. 7 put price at 58.137.

"Credit is always the first consideration in the current market. The credit assumption affects both the stock price inflection point, below which investors will probably put the bond, and also the company's options in terms of refinancing," the analysts said.

"Given current market conditions, we are forced to be extremely conservative in our approach when valuing XL Capital."

The asset swap to the next put in September 2003 is around Libor plus 300 basis points, the analysts noted.

"For an unsubordinated piece of debt rated A+ this is very wide, but the credit markets are in turmoil at the moment," the analysts said.

"The credit default swap picture is, if anything, even more of a mess. Natural buyers of short-dated XL protection are plentiful in the convertible arbitrage world, but finding matching protection sellers for one year is much more difficult."

The credit curve is inverted to reflect this and where five-year XL Capital credit default swap protection is offered at 200 basis points, one year protection is probably not tighter than the asset swap level of 300 basis points, the analysts said.

"XL Capital itself would almost certainly fare better if it accessed the market directly. Our fixed income analysts believe that XL Capital would probably be able to borrow (senior) in the straight market in the 1-3 year range at L+150-200 bps. Beyond three years the spread is probably more like L+220 bps," the analysts said.

"We therefore use L+300 bps when looking at the 2003 put. But given its short-dated profile, we tighten this to +225 bps for the 2002 put. When looking at the company's refinancing options, we assume a one/two year straight spread of L+200 bps. "

As for stock volatility, the analysts said when looking out to the 2003 put should be the best estimate of XL one-year volatility at a strike of around a $115. Volatility with this profile is probably around 27%-33%, so they used a conservative assumption of 30% for inflection point calculations.

Using the stated credit and volatility assumptions, the analysts calculate the current inflection point in XL stock to be around $79.

"This takes into account our view that the theoretical value of the bond needs to be 0.5 above the put price to ensure that a majority stay outstanding," the analysts said.

"But we feel that the combination of a good credit, another put in 2002 and a volatile underlier combine to mean that a significant number of bonds may stay outstanding even at lower stock prices."

With a put amount of $296 million, the cash required is not huge in terms of XL's balance sheet. As at 30 June, XL Capital showed $13.5 billion in total investments available for sale, with cash and equivalents at $2.3 billion.

"But despite its strong liquidity position, we believe that XL Capital might look at sweetening the put if it appears to be the most cost-effective way of financing for one year," the analysts said.

"Because the bond was issued by XL Capital, which is incorporated in the Cayman Islands (principal executive offices in Bermuda), we suspect that the contingent payment tax shelter is unlikely to be a key consideration for the company, and so the choice for XL Capital will probably come down to a simple calculation that compares the cost of sweetening the existing convertible with the cost of refinancing it. We assume that any sweetening will take the form of a cash payment, because the bond already has puts in 2003 and 2004.

The company's 0% convertible due May 2021 was putable in May 2002 but because the stock was well above the inflection point, no bonds were put and nothing was discovered about whether XL would have sweetened if necessary.

"If we assume, again conservatively, that XL Capital will compare the cost of sweetening with the cost of one year straight refinancing, then it is clear that the company is incentivized to do so if the stock if above $76," the analysts said.

"Should XL choose to refinance with two or three year debt, the stock price break-even can fall as low as $64. If stock is above 76, it may be cheaper for XL Capital to sweeten rather than refinance."

XL Capital 0% due September 2021

Ask Price: 58.625

Parity: 36.506

Premium: 61%

Equity Price: $69.18

Current Yield: 0%

Implied Volatility: 35.24%

Bond Floor: 57.94

Risk Premium: 1.11%

Delta (theoretical): 12%

Theoretical Value: 58.23

Stock Volatility: 32%

Credit Spread: 225 basis points over Libor

Dividend Yield: 2.72%

Stock Borrow: 50 basis points

Call: Sept. 7, 2004 at 61.553

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