Deutsche Banc estimates critical prices for 30 putable convertibles totaling $17.5 billion in 2002

By Ronda Fears

Nashville, Tenn., Jan. 16 - Deutsche Banc Alex. Brown convertible analysts Jeremy Howard and Jonathan Cohen estimate that there is some $17.5 billion of convertible paper with puts this year, which can be a highly profitable arbitrage opportunity.

But the analysts also note that it is important for all investors to judge the likelihood of a put being exercised in order to position their portfolios appropriately. They have identified 30 convertibles as put candidates for 2002 and the critical prices - inflection points - investors may use to decide what to do.

"The inflection point analysis is important because it helps identity bonds that are likely to disappear, and thus refinancing risks for corporates, and gamma trading opportunities for arbitrage funds," the analysts said in a recent report. "The approach of a put can be an extremely interesting situation for arbitrageurs if the stock is volatile around the inflection point as the put approaches. The optionality of the fixed put on the downside can be highly valuable close to the put date, causing the gamma in the security to increase substantially."

The idea is that if the stock is above the inflection point, the theoretical value of the bond will remain above the put price even as the put drops away. Whereas below this stock price, the drop in the bond floor as the put is lost takes the theoretical value below the put price. To calculate the inflection point, the analysts assume a static implied volatility and find the stock price at which the theoretical value of the convertible exactly equals the put value the day after the put date. The reasoning is that at this stock price an investor ought to be indifferent between holding and putting the bond. With the stock above the inflection point, an investor would lose theoretical value by putting the bond, below the inflection point the theoretical value will drop below the put price after the put passes.

Tyco International's 0% convertible due 2021 was used to illustrate the opportunities available. The put is in February 2003 at a price of 76.415 and, assuming an unchanged implied volatility of around 27.8%, the inflection point was calculated to be $66. The current gamma, or points move in delta for a one percentage point increase in the stock price, is 0.899. That in itself is an attractive gamma for an arbitrageur, the analysts noted, adding that if all the assumptions remain constant, the gamma rises from 0.899 to over 3.0 the day before the put date. That means that just before the put date for every 1% change in Tyco stock, the delta moves by over 3 points, giving holders a great gamma trading option.

"The potential to capture significant amounts of gamma close to the put date makes bonds such as the Tyco 0% 2021, where the stock is close to the inflection point, undervalued in our view," Howard and Cohen said in the report.

It is also crucial to understand the exact dateline of events because there are instances where a holder is permitted to put the bond but then withdraw it before the put is actually paid, as was the case with the Tyco 0% 2020 in November. Also important is determining whether the put is payable in cash or stock, or a combination, the analysts said.

Comcast set a precedent that provided yet another reason to hold putable bonds, the analysts said.

In December, the inflection point for the put on the Comcast 0.00% convertible due 2020 was sufficiently below the prevailing stock price to cause the bonds to be put back to the company in sizable quantities. The company had already announced it would pay the put in cash, so it was faced with the prospect of paying out a large proportion of the $1.2 billion put value of the bonds.

"What the company elected to do was, to our knowledge, unprecedented. By announcing that all bonds that were not put would enjoy another new put on Dec. 19, 2002, the company achieved its objective of persuading holders to un-put their bonds," the analysts said. "But as with all options, the company effectively bribed the market, perhaps by 0.5 point, thus giving holders an unexpected windfall and, in our opinion, yet another reason to consider putable bonds as extremely interesting special situations."

End

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.