Lehman analyst: New convertibles move stock sharply in first two days, regardless of marketing period

By Ronda Fears

Nashville, Sept. 24 - Venu Krishna, Lehman Brothers Inc.'s head of U.S. convertible research, said in a report Friday that the short-term impact of convertible new issuance on stock prices is typically a sharp downdraft in the first couple of days, but overnight issues don't cause a sharper move as is commonly thought.

A sample set of 261 new issues from June 30, 2003 through Aug. 3 was analyzed.

"Converts brought on an 'overnight' (61 of 261) basis fell just 2.98% compared to 4.63% for marketed deals, suggesting that the marketing period doesn't necessarily affect the magnitude of stock decline," Krishna said in the report.

"In addition, the results are counterintuitive to a more widely held belief that overnight issuance puts greater pressure on stocks."

He added that within the overnight group, stocks moved higher in 16 instances - 26% of the subset - and declined in the remaining 45 instances.

Rather, Krishna said, the stock impact "in good measure is likely to be driven by the amount of stock that could potentially be shorted by convertible arbitrage investors," which depends on the degree of equity sensitivity of the new convertible, the level of participation by convert arb players and the specific hedge ratios used to set it up.

"At the same time, the stock impact could be neutralized to varying degrees by events such as simultaneous issuer stock buybacks, call spread transactions etc.," he said.

At a macro level, Krishna said that fundamental equity investors who have a positive long-term view on the underlying stock should consider buying the stock in the first two days following a new convertible announcement, when most of the negative impact on the stock is concentrated.

On the other hand, he said arbitrage investors could consider laying out their hedges over a longer time frame based on the observed trends of the study.

"We observed an approximate four-fold spike in trading volume of the underlying stock in the week following the announcement of a convertible transaction," Krishna said in the report. "This was most noticeable in the first two days with an average six-fold increase."

On a normalized basis, underlying stocks declined by 4.25% on average on the first day. Overall, stock decliners outnumbered advancers by a ratio of 5.3-to-1.

He pointed out that 16% of the underlying stocks had a positive move, which he speculated could be due to issuer specific factors such as concurrent stock buybacks, positive signals of growth financing, increased financial flexibility, and the like.

Small and mid-cap issuers and low credit quality issuers saw markedly higher declines in the underlying stocks compared to large cap and higher credit quality issuers, he noted. In addition, where the delta adjusted shares of the convertible represented a higher proportion of the outstanding shares of the issuer, the declines in underlying stocks were significantly higher.

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