Lehman highlights five potentially cheap volatility plays in the convertible market

By Ronda Fears

Nashville, Feb. 10 - It is widely held in the convertible market that volatility will be on the rise in 2004 after slumping to historic lows over the past year or so. In an efficient and fully valued market like that of U.S. convertibles right now, however, Lehman Brothers analysts said the opportunity for cheap volatility plays are slim.

But there are a few possibilities, and in a report, Venu Krishna, head of U.S. convertible research at Lehman, highlighted five investment-grade convertibles with the lowest implied volatility. Those are issues of United States Cellular Corp., Scottish Re Group Ltd. (formerly Annuity & Life Holdings Ltd.), Best Buy Co. Inc., GATX Corp. and Cendant Corp.

The trend of implied volatility in the convert market over the past year has largely tracked that of the broader equity market, as measured by the VIX index.

Following a high of 34.7% in mid-February 2003, the VIX steadily declined, coinciding with the rally in stocks and bonds, finally hitting a three-year low of 14.3% on Jan. 21.

The decline in realized volatility also helped temper some upside in the convertibles market during 2003.

Illustrating the trend in investment-grade convertibles, he noted that since Jan. 15, 2003, the decline in high-grade convertible implied volatility has lagged that of 90-day realized volatility in the underlying stocks and the VIX.

High-grade convertibles implied volatility dropped from 28% on Jan. 15, 2003 to 29.4% on Jan. 30, 2004. The underlying stocks declined from 43.8% to 24.3% over the same period, and the VIX slumped from 25.5% to 16.6%.

"While investment-grade implied volatility in the convertible market lagged realized volatility prior to February 2003, it has since stayed ahead despite both showing a declining trend," Krishna said.

He also pointed out that the difference between implied volatility and realized volatility was highest during May and June of 2003 in a period of strong new issuance and rich pricing terms.

"This spread between implied and realized volatility continues to remain at elevated levels (currently around 5 points), likely reflecting the market's expectation for a future pickup in realized volatility as well as certain technical factors contributing to a fully valued secondary market," Krishna said.

"To the extent that limited opportunities in this area of the market still exist, we have highlighted the top five investment-grade convertible bonds (excluding busted securities) with the lowest implied volatility relative to their underlying stocks' 90-day realized volatilities.

Those were:

US Cellular's 0% convertible due 2015, a $362 million issue with terms of 5.91%, up 41.4%. The issue is trading at about 52 with the stock at $38.85. Lehman estimates fair value at 54.5. The implied volatility is 12.2% versus the realized volatility of 29.3%. The option-adjusted credit spread is 249 basis points.

Scottish's 4.5% convertible due 2022, a $115 million issue with terms of 3.75%, up 20.2%. The issue is trading at about 120 with the common stock at $21.69. Lehman estimates fair value at 117. The implied volatility is 25.6% versus the realized volatility of 41%. The option-adjusted spread is 220 basis points.

Best Buy's 0.684% convertible due 2021, a $492.4 million issue with terms of 2.5%, up 25.1%. The issue is trading at about 74.5 with the stock at $50.39. Lehman estimates fair value at 76.88. The implied volatility is 19.7 versus the realized volatility of 32.3%. The option-adjusted spread is 251 basis points.

GATX's 7.5% convertible due 2007, a $175 million issue with terms of 7.09%, up 59.7%. The issue is trading at about 105.875 with the common at $22.60. Lehman estimates fair value at 105.96. The implied volatility is 32.7 versus the realized volatility of 42.7%. The option-adjusted spread is 505 basis points.

Cendant's 3.875% convertible due 2011, an $804 million issue with terms of 3.59%, up 14.5%. The issue is trading at about 107.75 with the stock at $22.65. Lehman estimates fair value at 110.84. The implied volatility is 9.3% versus the realized volatility of 19%. The option-adjusted spread is 204 basis points.

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