Lehman analysts suggest long swap out of GM stock into 5.25% or 6.25% convertibles; like 6.25s best

By Ronda Fears

Nashville, May 10 - In the wake of General Motors Corp. credit getting cut to junk, Lehman Brothers Inc. convertible analysts said the risk/return characteristics of the 6.25% convertibles offer several compelling reasons to swap out of the common, or also as a swap out of the 5.25% converts, into the 6.25s.

For equity investors the GM 5.25% and 6.25% convertibles are alternatives worth a look as a long swap out of the common into the convertibles, the analysts said, and the Lehman analysts believe the 6.25% convertible is a better alternative of the two given relatively more attractive terms and risk-reward profile.

With the 6.25% bonds offered at $19.25 versus a stock price of $30.76, given significant credit spread widening, the 6.25s provide a 3-to-1 risk/reward profile with 90% upside participation and 30% downside participation should the stock move up to $35.00 or down to $25.00 over the next year, the analysts estimate.

A swap out of the common would be a move up in the capital structure with significant upside participation, too.

The current yield of 8.11% on the 6.25% convertible offers 161 basis points of income pick up over the stock, the analysts pointed out. Should dividends be cut by half, they added, the pick up increases to 486 bps.

In addition, the convertible will significantly outperform the common stock if GM cuts its common dividend. For example, if the common dividend is cut in half and the stock price remains unchanged over the next year, the Lehman analysts estimate the convertible will return 14% versus the common stock's total return of 3.25%.

There is reasonable breakeven - the number of years to recover premium via income pick up - with significant upside if the dividends are cut, as well, the analysts said. At current levels the breakeven is 6.1 years, but if GM cuts its dividends by half, the breakeven falls to just 3.0 years and the fair value of the convertible increases by 6.4% to 20.71.

Out of 5.25s into 6.25s

A swap out of the 5.25% convertibles into the 6.25% convertibles also makes sense, the analysts said.

The $4.3 billion 6.25% has a 9.31% yield to put, 19.2% premium, an 8.11% current yield and 161 basis points of income pick up over the common stock at 19.25 versus $30.76 for the stock. Theoretical value is estimated at 19.47, or 1.14% cheap, using a 35% volatility and a credit spread of 1,000 basis points over Libor.

If the common dividend were to be cut by half, the 6.25% convertible would provide 486 bps of income pick up.

The $2.6 billion 5.25% convertible has an 11.37% yield to put, 40.1% premium, a 7.91% current yield and 141 bps of income pick up at 16.60 versus $30.76 for the stock. Theoretical value is estimated at 17.06, or 2.74% cheap, using a 32% volatility and a credit spread of 1,000 basis points over Libor.

If the common dividend were to be cut by half, the 5.25% would provide 466 bps of income pick up over the common stock. Investors will cut premiums by almost 21%, the analysts pointed out, and extend call protection by 1.4 years and extend the put date by 4.4 years. There also is a 20 bps income advantage in the 6.25% issue based on current yield. Also, while the 5.25s are incrementally more defensive on the downside, the 6.25s provide greater incremental returns on the upside.

Using a 35% volatility and a credit spread of 1,000 bps over Libor, the 6.25s would have a negative 3.7% total return with the stock at $25.00, a 7.9% total return with the stock at $30.76 and an 18.2% total return with the stock at $35.00. If GM cut its common stock dividend to $1.00, using a 35% volatility and a credit spread of 1,000 bps over Libor, the 6.25s would have a 1.7% total return with the stock at $25.00, a 14.0% total return with the stock at $30.76 and a 24.8% total return with the stock at $35.00.

Using a 32% volatility and credit spread of 1,000 bps over Libor, the 5.25s would have a total return of 2.0% with the stock at $25.00, an 8.8% total return with the stock at $30.76 and a 14.6% total return with the stock at $35.00. With the common dividend cut to $1.00, using a 32% volatility and credit spread of 1,000 bps over Libor, the 5.25s would have a 4.0% total return with the stock at $25.00, an 11.6% total return with the stock at $30.76 and a 17.9% total return with the stock at $35.00.

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