Merrill pitches global convertibles to traditional equity investors for greater returns, less risk

By Ronda Fears

Nashville, Aug. 25 - Merrill Lynch & Co convertible analysts were pitching convertibles to traditional equity investors in a report Wednesday, pointing out that over a 7.5-year period convertibles have offered greater returns than stocks with lower risk.

The risk free rate is currently 3.7% based upon average three-month U.S. Treasuries over the 7.5-year period. The Merrill data showed corporate bonds had a 6/8% annualized return with 5.3% annualized volatility while equities returned 4.6% with 16.2% volatility and convertibles returned 6.3% with volatility of 9.9%.

Convertible ideas recommended were:

* In the U.S., the General Motors 6.25% bond, Freeport-McMoRan Copper & Gold 7% bond and Schering-Plough 6% mandatory issue;

* In Europe, the Alcatel 4.76% bond, ASML 5.5% bond and Infineon 5% bond;

* In Japan, the Sapporo 0% bond and Takefuji 0% bond;

* In Asia, the Formosa Petro Chemicals 0% bond and Nanya Tech 0% exchangeable into Nanya Plastics.

The analysts noted that all the recommendations above are for issues that are sub-investment grade or unrated.

"Whilst there are no guarantees that history repeats itself, when markets get very depressed and credit concerns also arise, credit spreads for these types of issues are more vulnerable," the analysts said in the report. "Having said this, an interesting exercise is to look back at 2002 when share prices fell and credit spreads moved dramatically wider for two convertibles from ASML and Infineon."

United States ideas

GM's 6.25% issue combines high current yield with upside potential should the stock appreciate. The analysts estimate the convertible risk/reward ratio is almost 3-to-1 over a one-year horizon period, with a total return of 14.9% on the upside versus and a decline of 4.9% on the downside for a 25% move in the stock. At 27.74 for the convertible versus $41.36 for the stock, the convert has a 27.8% conversion premium, 5.6% current yield and a 5.5% yield to maturity. The issue carries dividend protection.

Freeport-McMoRan's 7% issue is trading at 147.75 with a conversion premium of 28%, versus $35.63 for the stock, with a current yield of 4.7% comparing favorably to the stock dividend yield of 2.3%. The analysts estimate that over a one-year period, the convertible will show a total return of 17.5% and a drop of 11.4% for a 25% move in the stock. Using a credit spread of 465 basis points and a 42.4% equity volatility, they estimate the convertible is trading at a 2.2% discount.

Schering-Plough's 6% issue offers greater current yield and a superior risk/reward profile than the stock. Using a credit spread of 154 basis points and 27.8% equity volatility, the analysts estimate the issue is trading at a discount of 2.6%. The issue offers a significant yield advantage to the common, with a current yield of 5.8%, or 459 basis points more than the stock dividend yield. Additionally, they estimate the convertible's total return would rise 18.9% or drop 15.1% for a 25% move in stock over a one-year period.

European ideas

Alcatel's 4.75% issue provides a large yield advantage over the shares, which do not pay a dividend at present. It is callable after June 2008 at par plus accrued interest with a 125% parity hurdle. The analysts calculate the issue's delta at 29% and a one-year return profile of 8.4% to the upside or 4.3% to the downside in response to a 25% move in the stock over a one-year horizon.

ASML's 5.5% issue offers yield advantage over the stock, which does not pay a dividend at present. The subordinated bond is callable after May 2006 at par plus accrued interest with a 150% hurdle. The analysts calculate delta at 39% and a one-year return profile of 10.7% to the upside or 6.6% to the downside for a 25% move in the stock.

Infineon's 5% issue provides a large yield advantage over the shares, which do not pay a dividend at present. The bond is callable from June 2006 at par plus accrued interest with a 125% parity hurdle. The analysts calculate delta at 38% and a one-year return profile of 9.9% to the upside and 5.9% to the downside for a 25% move in the stock.

Ideas in Japan

Sapporo's 0% issue is appealing first for its price of 104.5, which is not far from the bond floor at 98.4 on a credit spread of 30 basis points, the analysts said. They also pointed to the implied volatility without stock borrow of 26.8% as a good discount to the 90-day historical volatility in the stock of 32.2% and noted the 19.3% delta gives fair equity exposure.

Takefuji's 0% issue is only at 6.8% premium to bond floor, the analysts said, adding that the 29.8% delta is giving the convertible good equity exposure. The convertible's implied volatility, without stock borrow, is at 33.5%, which the analysts said is a large discount to the stock's 90-day historical volatility of 42.1%. The analysts pointed out, too, that Takefuji's credit spread has tightened recently and the solid bond floor should give the convertible more grounds for investors seeking for equity exposure.

In Asia

Formosa's 0% bond trades at a 2% premium to equity value, the analysts said. It pays no coupon but suffers no disadvantage over the stock, either, they said, as the bond fully adjusts for common stock dividends. Free float in the underlying share is limited, they pointed out, so the convertible provides a more liquid, alternate vehicle for long equity investors. The analysts estimate that a 25% move in the stock over a year would produce a 23% return on the upside or a 6.7% decline on the downside.

Nanya's 0% issue is a prudent way of participating in the potential upside of the stock, the analysts said. The bond has a delta of 35% and trades at 10 - only 5.5% above the bond floor, thus limiting the downside in case of a stock price crash. If Nanya is able to execute its partnership with Infineon well as well as gear up chip production, there is potential for the stock to do well over the next 12 to 18 months with the bond registering a decent risk adjusted return, the analysts said.

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