Deutsche analyst finds $29.8 billion of convertibles with call, put risk in 2004

By Ronda Fears

Nashville, Jan. 26 - About $29.8 billion of convertibles face puts in 2004, following heavy redemptions in 2003, said Robert Barron, head of U.S. convertible research at Deutsche Bank Securities. But Barron said he expects fewer issues will go away this year.

Key for holders, he said, are issues in which there is some call protection remaining after the put dates.

Deutsche estimated $23.6 billion of convertibles were callable or putable in 2003 versus $17.5 billion in 2002.

"What's new for 2004? Call risk for one thing. Issuers' propensity to call convertibles in 2003 has left the market with a lot less paper and may have investors thinking twice before putting a convertible," Barron said in a report Monday, noting that many of the puts in 2004 will simultaneously signal the expiration of call protection.

Indeed, already in 2004 two potential puts - on the Jones Apparel Group 0% due 2021 and Cendant 0% due February 2021 - have already been called.

"2004's puts, therefore, naturally bifurcate into those with call protection remaining and those with call protection expiring. Along these lines, when an issuer considers sweetening a convertible we may see call protection extension instead of, or in addition to cash payments," Barron said.

"Low interest rates, tighter credit spreads and rising equity prices have created theoretical values that will save some issues that would have been put candidates in the past. We anticipate that in 2004 fewer puts will be exercised than in 2002 or 2003."

While non-investment-grade companies are likely to call in-the-money convertibles, many high-grade issuers may leave such issues outstanding to avoid dilution, he added.

Further complicating analysis of put sweeteners and potential calls are the tax implications for issues with contingent payment features. With up to three years of accrued tax benefits, many issuers will scramble to keep the tax benefits alive without triggering a tax recapture.

Similarly, he said, investors need to be aware of how contingent conversion features affect company decisions.

"In the current low interest rate, tight credit spread environment, convertibles with call protection remaining past the 2004 put will have increased value to investors, increasing the likelihood that these bonds will remain outstanding," Barron said.

"Additionally, many of the stocks underlying these convertibles have risen significantly since issuance or the last put date, giving rise to higher deltas and greater gamma trading opportunities. For many convertibles, two to three years of additional call protection are accompanied by a put on the first call date, creating low-risk, short-dated gamma trading scenarios."

Among issues with call protection after the put date, the following actions are possible:

Likely to remain outstanding:

SPX Corp. #1 0% due 2021, $625 million - at current stock price the put is not likely to be exercised; the current inflection point on stock using Libor plus 180 basis points and 24% volatility is roughly $47.

Countrywide Financial 0% due 2031, $516 million - deep in the money, with two years of call protection, so there's no reason to exercise the put.

TJX Corp. 0% due 2021, $369 million - low premium name attractive to arbitrageurs; given the substantial tightening of TJX's credit spread since issuance, lower interest rates and three years of call protection, the bond floor is above the put price.

Franklin Resources 0%, $526 million - investors may be looking for a sweetener, but the stock is trading $10 above the inflection point; with two years of call protection remaining beyond the put date, the company may not have to do anything; should fund flows remain strong and the performance of its funds remain strong, this put will probably not be exercised.

Royal Caribbean #2 0% due 2021, $398 million - in the money with two years of call protection remaining, there is no reason to exercise the put.

International Paper 0% due 2021, $1.12 billion - almost too close to call, but a solid investment-grade credit with exposure to further economic recovery and two more years of call protection make it likely that this issue will remain outstanding; using Libor plus 40 basis points credit spread and 21% volatility gives an inflection point of $46.

PMI Group 2.5% due 2021, $360 million - credit would have to widen substantially for this issue to be put.

HCC Insurance 2% due 2021, $173 million - with nine months to the put date, anything can happen, but at the moment it is unlikely that this issue will be put; using Libor plus 75 basis points and 17% volatility gives an inflection point of roughly $25.25; this bond represents an at-the-money issue, low premium, high gamma convertible with a low credit spread and two years of call protection; hedged investors should fair well if any volatility event occurs before the put.

Gtech Holdings Corp 1.75% due 2021, $175 million - this bond is deep in the money with two years of call protection remaining, a good low premium issue.

Special case - Omnicom

Omnicom Group 0% due 2031 and 0% due 2032, which total $847 million and $892 million, respectively.

In the past, Omnicom has shown a clear desire to keep its convertible debt outstanding by offering investors sweeteners in order to not exercise puts.

Omnicom stock is higher and its credit spread is tighter than the last time it sweetened, increasing the likelihood that these issues will remain outstanding. Additionally, the company's earnings have improved and its balance sheet appears healthier than in prior years.

However, there is always reason to hope for another sweetener.

With that said, the current inflection points on each of the convertibles are only slightly higher than current stock prices, with the inflection point on the 31s at $85.50 and the 32s at $84. Barron noted that the inflection points on both bonds are extremely sensitive to credit and volatility assumptions.

Both Omnicom convertibles offer investors puts every 12 months with three years of call protection on the 32s and two on the 31s. Each of these bonds offers investors low premium exposure to Omnicom, with the rolling puts sustaining the bond floor and increasing the opportunity to capture any volatility events.

Finally, Omnicom's history of offering sweeteners leaves open the possibility that it may do so in the future. For investors looking for a place to invest capital while waiting for the market to cheapen or other opportunities to appear, these bonds may be the way to go.

Those likely to be put

Neuberger Berman 0% due 2021, $146 million - in the fall of 2003 Lehman Brothers acquired Neuberger Berman for cash and stock, resulting in this issue being convertible into $131.80 in cash and 6.5843 shares of Lehman. On two separate occasions in the past, Neuberger sweetened this bond with cash payments. The last of these sweetener payments is due on this year's put date. However, Lehman may choose to deal with this issue differently, so a sweetener may be out of the question.

With the improvement in credit spread following the acquisition, there is still a decent chance that this bond will remain outstanding. Finally, in all of the recent put sweetener examples none include an investment bank issuer, so there is no precedent for how such institutions will behave. Current inflection point is roughly $90 versus recent levels in the low $80s.

Solectron #3 0% due 2020, $953 million - Solectron has been scrambling for the past two years via tender offers and aggressive open market purchases; the company should just squeak through this one with cash on hand.

Amdocs 2% due 2008, $400 million - will more than likely be put, and Amdocs is prepared for this; even though the stock has risen from its lows, it is still well below the price needed to keep this issue outstanding.

Calpine Corp. 4% due 2006, $1.05 billion - following recent capital raising activity Calpine seems to be in a position to pay this with cash.

Those too close to call

Vishay Intertechnology 0% due 2021, $232 million - following its $500 million convertible offering this past summer - the 3.625% due 2023 - and solid operating performance, Vishay has more than $500 million of cash on the balance sheet to fund this put; however, it is early and the stock could continue to rise above the likely-to-be-put range.

Chiron Corp. 0% due 2031, $427 million - with two years of call protection beyond put date it is likely that this issue will remain outstanding; the inflection point is roughly $51 using Libor plus 40 basis points and 28% volatility.

Fiat/GM 3.25% due 2007, $2.2 billion - a question that has been nagging the convertible markets since this jumbo exchangeable was issued, is will Fiat survive the put; the run in GM stock and a tightening Fiat credit may be the answer to this question; also helping Fiat is the fact that this issue is non-callable for life; in the current market a bond with a 3.25% coupon and three years of call protection is rare and attractive.

Eaton Vance 0% due 2031, $152 million - sweetened twice already with the final cash payment coming on the August 2004 put date; stock is slightly below the inflection point, but anything can happen between now and August.

Laboratory Corp. of America Holdings 0% due 2021, $530 million - another issue that is just too close to call at this point. LabCorp stock is within $2 of the inflection point and call protection post put sustains the valuation.

Medtronic 1.25% due 2021, $1.97 billion - at this point it is too close to call as the stock is roughly $2 above the inflection point; a lot can happen between now and Sept. 15, however, so we think this will remain one of the more interesting issues; a decent volatility event in the next nine months would be nice.

Among interesting issues with post-put call protection are:

Verizon Communications 0% due 2021, $3.28 billion - this put will likely be a game of chicken between investors and the company. The stock is trading a bit below the $46 inflection point, but is in a range where a one-time cash sweetener could mean the difference between putting and not putting. With call protection until 2006, a cash sweetener seems to be a decent possibility. Again, credit and volatility to the next put are key assumptions.

Merrill Lynch 0% due 2031, $2.5 billion - Merrill stock is above the inflection point, but four months remain to the put date. As there is no precedent of an investment bank sweetening a convertible, so this issue will be interesting to watch. The size of the liability and the possibility of significant tax recapture make it even more interesting. Investors have puts in 2005 and 2006 and it is callable in 2006, so the 2004 put may not be the time to push Merrill for a sweetener.

Among issues without call protection after the put date, the following actions are possible:

Those likely to be put:

Citrix Systems 0% due 2019, $378 million - stock would still have to rise significantly from current levels to not exercise this put.

Jabil Circuit 1.75% due 2021, $345 million - at current stock prices, this issue is likely to be put; however, a sweetener that includes extending call protection to the 2006 put would likely keep it outstanding.

Cooper Cameron 0% due 2021, $260 million - this put should be exercised and the company will most likely refinance it with another convertible.

AOL Time Warner 0% due 2019 - this issue will be put as part of the company's massive debt repayment program.

Those likely to be called

Idec Pharmaceuticals 0% due 2019, $153 million - following acquisition of Idec by Biogen, this bond will likely be called for conversion; it is deep in the money.

Lowes Cos. 0% due 2021, $659 million - likely to be called as this issue has no contingent features as incentives to keep it outstanding; the dilution impact of shares underlying convertible are already being reported, so calling this bond does not change diluted earnings per share and allows Lowes to simplify its capital structure.

First Data Corp. 2% due 2008, $542 million - company will more than likely want to call for cash than complete conversion, but stock is moving higher; it is currently at the money, with a low premium; company may prefer to keep contingent payment tax advantage alive by not calling this issue if it is in the money; the actual cash cost of 2% compares to the tax deductible cost of debt at 6.35%.

Starwood Hotels #2 0% due 2021, $331 million - really could go either way; investors are probably as likely to put this issue as the company is to call it.

AnnTaylor 0.55% due 2019, $125 million - if the company can call for stock we anticipate it will; this bond does not have contingent features that might cause the company to want to keep it outstanding; however, the company still does receive the tax deduction for the actual cost of debt.

Manpower 0% due 2021, $262 million - as the stock approaches the contingent conversion threshold, it becomes increasingly likely that Manpower will call this; additionally, this security does not have contingent payment tax benefits, making it likely that refinancing with a contingent convertible would appeal to the company.

Teva Pharmaceuticals 0.75% due 2021, $360 million - we see more call risk than put risk at this point, especially following Teva's recent jumbo convertible offering; parity is above the contingent conversion trigger, so dilution is not an issue.

Apogent 2.25% due 2021, $300 million - Apogent recently issued a $300 million floating-rate convertible with proceeds going to stock repurchase and repayment of its credit facility; the only reason to keep this issue outstanding is to continue to claim the tax benefits associated with the contingent payment feature; we are still on the fence as to whether this will be put or called.

Those too close to call

Lehman Brothers Holdings floater due 2022, $575 million - since issue, interest rates have fallen, Lehman's credit spread has tightened and the stock is higher, giving this bond additional value, but that is not enough once it becomes callable; however, as the first investment bank issuer of contingent convertibles to face a sweetener situation, it will be interesting to see how Lehman handles the sweetener option; extended call protection would probably keep this issue outstanding and may not force a tax recapture.

Masco Corp. 0% due 2031, $805 million - Masco does not fit neatly into either the likely to be put or called category. The bond has been sweetened in the past, so there is always the option that the company will sweeten again. The issue has soft call protection at a 140% hurdle, a roughly $47 stock price trigger, through the put date and then at 130% through January 2007. Since its last put date, Masco's credit spread is more than 100 basis points tighter and the stock is higher, creating a situation where the bonds may just squeak through the put.

Best Buy 0.684% due 2021, $355 million - Best Buy stock is trading above the inflection point, making it likely that the company will leave this issue outstanding; however, Best Buy does have more than $1.8 billion of cash and marketable securities on its balance sheet, making a cash call possible.

Avaya 0% due 2021, $298 million - Avaya has taken an active role in trying to reduce this liability by conducting a tender and open market repurchases; it was very likely to be put, but recent stock move has put parity above put price; the company would like to do away with this issue and will likely call if parity remains above put/call price; however, Avaya would be able to handle put with cash on hand.

Cendant 3.875% due 2011, $804 million - now that Cendant has called its #1 0% due 2021, which was also putable in February, we think the company will also call the 3.875% issue. Currently, this issue is trading above its inflection point (parity just below par) and it will likely not be put.

The case for not exercising the put has also been helped by tighter credit spreads, but this bolsters the call case. Cendant has stated that it will begin paying a dividend in 2004, which dampens theoretical valuations going forward and strengthens the put case. The #1 0% convertible was called for stock, but Cendant has said that it will repurchase up to 22 million shares to limit dilution. We suspect the company may do the same with this issue.

Quest Diagnostics 1.75% due 2021, $250 million - the stock is above the inflection point even with call protection expiring on the put date. With parity 10% below par and almost 10 months to the put date, there is reasonable likelihood that the bond will be in the money in November. If this is the case, we expect that Quest would rather leave this issue outstanding and continue to gain the contingent payment tax advantage instead of issuing equity. This of course all changes if parity is above the 120% contingent conversion trigger.

Without post-put call protection

XL Capital #1 0% due May 2021 and #2 0% due September 2021, $649 million and $339 million, respectively.

If XL were to do nothing to entice holders to not exercise the puts, both bonds would be put. Even with XL credit as tight at Libor plus 30 basis points, the loss of call protection on each issue leaves the bonds worth less than the put prices.

The question then becomes whether or not the company will sweeten.

As a Bermuda company, XL has no added tax incentive to keep the convertibles outstanding, despite the fact that both have contingent payment features, leaving only an economic basis for the sweetener decision.

Given the company's recently announced charges and proposed mandatory convertible to be used to shore up reserves associated with the charges, the economics of the May put become more interesting. XL does have access to the capital markets, so redemption/refinancing is an option, though a small cash sweetener and an extension of call protection would probably keep this outstanding.

The current inflection points on the XL May and September convertibles are $98 and $105, respectively. If XL were to add two years of call protection to each bond, the inflection points drop to $76 and $86 for the May and September convertibles, respectively.

As the May liability is significantly larger, we feel that there is a higher probability of this issue being sweetened.

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