Merrill analyst finds opportunity in convertibles that could see call premium expand on higher rates

By Ronda Fears

Nashville, May 17 - As interest rates rise, call premiums on convertibles should eventually increase, leading to opportunities in those converts sensitive to call threats, said Merrill Lynch convertible analyst Marc Malloy.

"Call delay for most convertibles has been almost completely erased. This is markedly different from about a year and a half ago when call premiums hovered around 15% for investment-grade and 20% for speculative-grade convertibles," Malloy said in a report Monday.

"However, in the current market environment of low interest rates coupled with very attractive terms in the primary markets, companies are calling their convertibles at an ever-increasing rate.

"We believe this trend will not continue in the long term and that call premiums will likely rise as interest rates increase and the refinancing boom slows."

So, looking at the Merrill Lynch universe of tradable U.S. convertibles, excluding mandatories, with market values above $150 million, the analyst modeled their valuations after changing the call premium from 0% to 15%.

"The results confirm what we thought going into this analysis - that the valuations of currently callable and issues callable within one year are most affected by call delay. Also, convertibles with lower premiums are more affected by changing call premiums," Malloy said.

On an outright basis, he said, the potential gains are small but "investors with the ability to leverage their positions can potentially capture significant gains."

Convertibles most affected by call delay with one to two years of call protection remaining were the Tyco 2.75% due 2018, Lennar 0% due 2021, International Game Technology 0% due 2033, Skyworks Solutions 4.75% due 2007, Waste Connections 1.67875% due 2022, Micron Technology 2.5% due 2010, General Mills 0% due 2022 and Weatherford International 0% due 2020.

Convertibles most affected by call delay with two to three years of call protection remaining were the Royal Caribbean 0% due 2021, Legg Mason 0% due 2031, St. Paul (Travelers) 4.5% due 2032, MGI Pharma 1.6821% due 2024, Medtronic 1.25% due 2021, Universal Health 0.426% due 1020, Supervalu 0% due 2031 and Best Buy 2.25% due 2022.

Convertibles most affected by call delay with two to three years of call protection remaining were the Tyco 3.125% due 2023, Selective Insurance 1.6155% due 2032, American Tower 3.25% due 2010, RF Micro Devices 1.5% due 2010, Sealed Air 3% due 2033, Chiron 1.625% due 2033 and Halliburton 3.125% due 2023.

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