Lehman says rich mandatories ripe for pullback, but some still attractive

By Ronda Fears

Nashville, Jan. 31 - Mandatory have richened recently, which Lehman Brothers convertible analysts believe will necessitate a pullback. Still, they find a few worth considering as buy candidates.

"While the convert market has generally been rich, it has been particularly eye catching in parts of the $25.7 billion mandatories segment since historically they have generally tended to trade 2%-3% cheap to theoretical valuations," said analysts Venu Krishna, Brendan Lynch and Jocelyn Picl in a report.

Based on what the analysts consider "a conservative approach," the overall mandatory market is currently 0.70% rich on a weighted basis, compared to a richness level of 0.17% for the whole convertible market.

"A closer examination of valuations in the mandatory market revealed an interestingly bifurcated market," the analysts added.

"Over 80% (in market value) of mandatories are either rich or fully valued. Around 19% of mandatories are rich with an average (non-weighted) richness of 10.17% while the 20% are cheap with an average cheapness of 3.92%."

Current valuations of mandatories make them susceptible to a pullback, as the analysts do not believe the levels are sustainable over time.

Two generic factors appear to have caused mandatories to richen in recent months, the analysts said.

"Outright investor demand driven by the higher yields mandatories offer and an expectation of a pickup in the equity markets that would benefit the equity-sensitive mandatory structure," have helped performance they said, adding there has also been a boost from "hedge funds, wary of taking on credit exposure, viewing mandatories as 'cash flow' trades with relatively low risk."

Factors that could cause cheapening include the onset of negative gamma, erosion of the unit structure premium, increase in common dividends and a pickup in new issue volume.

Mandatories most susceptible to cheapening, the analysts said, are:

Teco Energy Inc.'s 2.375% convertible due 2005, which at 18.45 bid with the common at $14.42 is 20.87% rich.

Williams Cos.' 2.25% convertible due 2005, which at 8.75 bid with the common at $3.17 is 15.92% rich.

Duke Energy Corp.'s 2.063% convertible due 2004, which at 14.64 bid with the common at $17.13 is 13.82% rich.

Duke Energy's 2.0% convertible due 2004, which at 14.75 bid with the common at $17.13 is 11.11% rich.

Motorola Inc.'s 3.5% convertible due 2004, which at 32.10 bid with the common at $8.50 is 8.95% rich.

CMS Energy Corp.'s 1.813% convertible due 2003, which at 12.10 bid with the common at $5.70 is 0.31% rich.

Despite the general valuation concerns, the analysts also found a few reasonably valued mandatories with decent fundamental prospects that are worth considering as buy candidates. Those are:

Ace Ltd.'s 4.125% convertible due 2003, which at 57.36 bid with the common at $28.05 is 2.0% cheap.

Alltel Corp.'s 3.875% convertible due 2005, which at 50.86 bid with the common at $50.22 is 1.06% cheap.

Affiliated Managers Group's 1.5% convertible due 2004, which at 19.27 bid with the common at $50.71 is 1.0% cheap.

CenturyTel Inc.'s 1.719% convertible due 2005, which at 26.33 bid with the common at $30.42 is 0.74% cheap.

Prudential Financial Inc.'s 3.375% convertible due 2004, which at 55.70 bid with the common at $32.40 is 0.74% cheap.

Capital One Financial's 3.125% convertible due 2005, which at 30.90 bid with the common at $32.80 is 0..35% cheap.

MetLife Capital Trust's 4.0% convertible due 2003, which at 84.89 bid with the common at $27.89 is 0.16% rich.

Express Scripts' 4.83% convertible due 2003, which at 95.46 bid with the common at $53.73 is 0.83% rich.

Household International's 2.219% convertible due 2005, which at 30.43 bid with the common at $27.21 is 1.09% rich.

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