Bear Stearns analysts identify convertibles for arbs looking to buy cheap volatility

By Ronda Fears

Nashville, Tenn., Sept. 20 - In a universe of mostly busted convertibles it is increasingly difficult for arbitrageurs to find issues with low premium and a decent credit standing. Bear Stearns & Co. convertible analysts found 14 , but also note that liquidity is somewhat a barrier.

"The convertible universe, as reflected by the Bear Stearns 500 Convertible Index, has deteriorated to a point that 60% of the universe is busted. We define busted securities as having more than a 70% conversion premium," said analysts Rao Aisola, Matt Hempel, Sarah Gallagher and Tom Suguira in a report Friday.

"As a consequence, traditional convertible arbs must be hard pressed to find cheap volatility names with relatively low premiums and that also represent decent credit."

The analysts ran a screen to identify names with conversion premiums of less than 70% and implied credit spreads of less than 1,000 basis points to keep volatility constant, then further restricted the list to coupon-paying securities so as to facilitate a positive carry.

"In our valuation we used swap spreads when available and capped volatility at 50%," the analysts said.

"As for call implied volatility, we picked the longest dated call (or closest to the put date) with a strike close to the conversion price."

Based on those parameters and some minimal balance sheet analysis, they came up with a list of 14 that may present a good arbitrage set up.

One caveat is that some of these issues are small and hence illiquid.

Those identified so far are: Barnes and Nobles 5.25% due 2009, Cendant 3.875% due 2011, Charming Shoppes 4.75% due 2012, Devon Energy/ChevronTexaco 4.9% due 2008, Electronic Data Systems 5.3% due 2007, First American 4.5% due 2008, Gap 5.75% due 2009, Harris 3.5% due 2022, Kerr-McGee 5.25% due 2010, Liberty Media/Viacom 3.25% due 2031, Medtronic 1.25% due 2021, Northrop Grumman 7.25% due 2007, OmniCare 5% due 2007 and Pogo Producing 5.5% due 2006.

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