Merrill advises buying XL Capital issue due in May, shorting September issue

By Ronda Fears

Nashville, March 19 - Merrill Lynch & Co. convertible analysts believe the difference in trading levels between the two XL Capital Corp. convertibles presents an opportunity, suggesting a strategy of buying the May issue and shorting the September issue with five-year credit default protection.

The situation is presented as an "idea of the week" in the debut issue Wednesday of a weekly report to screen for hedge opportunities by the Merrill convertible research team.

The XL 0% due May 2021 and 0% due September 2021 rank pari passu in terms of seniority, the analysts note, but the September converts have a put date in September 2003, whereas the May converts have a put in May of 2004.

"Based on the shorter maturity of the September bonds, investors have been pushing up the price of the September convertibles while pushing down the price of the Mays," said Yaw Debrah, head of U.S. convertible research at Merrill, in the report.

At current levels of 60.75 bid, 61 offered for the September issue and 63.125 bid, 63.375 offered for the May issue - both versus a stock price of $69.95 - and assuming a credit default swap level of 130 basis points, the September issue is trading at a 39.5% implied volatility, while the May issue is at 25.8%.

"We consider the difference in implied volatility between the bonds excessive," Debrah said.

The suggested strategy involves buying the May issue, shorting the September issue and buying the five-year credit default swap.

"An investor makes a positive return on the small amount of capital invested in the trade, after payment of the CDS and taking into account cash flow payments," Debrah said, outlining four scenarios that could transpire.

In the event XL goes bankrupt before the September put date, he said an investor would lose by being long the May issue, but that would be offset by being short the September issue and would "make a killing" on the credit default swap.

If XL's stock declines prior to the September put date, the credit default swap will blow out. If a sweetener is not an option and the company pays the put, then the May issue is left outstanding.

"Since you were short Seps, you make a buck (60.875 minus the 59.82 put price)," he said.

"Since you have CDS protection on the Mays, you know that at the very least, you will get your put payment on the put date in May 2004 from the CDS, if the company is unable to make good on the put. You make a buck on the position (64.125 minus the 63.125 put price).

"Hence you make a buck being short the Seps and make a buck being long the Mays - prior to payment of CDS and cash flow implications."

If XL shares are at level where it is economically feasible for company to pay a sweetener, then investors can still make money in the overall picture.

"Let's say XL pays sweetener of $1-$2. This is a total price of 60.8-61.8. (Put price is 59.82)," Debrah said.

"You shorted the bonds at 60.8, therefore your loss is 0-1 points. You are now long the XL bond with the shorter put date to May '04 and short the bond with the longer put date (September 2004).

"It is reasonable to expect a similar price to develop in favor of the May as the put date approaches that we see now in favor of the Seps. If this situation develops as expected, this would be up to a 4-point swing in favor of the Mays over the Seps."

That would more than offset the up to one point loss from the sweetener payment , he said, with potential profit of up to three to four points before payment of the credit default swap and cash flow implications.

If a sweetener is not an issue, he said, the May and September issues will likely equalize in price at least.

"Mays now richen post-September put date because they have the next closest put date," Debrah said, and the profit potential is up to 4 points.

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