Synthetic convertibles find more interest amid issuance trough, Merrill reports

By Ronda Fears

Nashville, March 3 - Synthetically created convertibles may be a new frontier for opportunities in convertibles and certainly have gotten more attention amid the dearth of issuance in the standard convertible market, Merrill Lynch analysts said in a special report on the investment idea Thursday, following a specific recommendation for a synthetic convertible into HCA Inc. last week.

Market players say synthetics have merit but opportunity is limited because of liquidity constraints in these issues. Convertible traders at some of the big sellside shops, though, have noticed increased interest in synthetics for lack of much else to look at in the standard convertible market.

"They [synthetics] definitely have seemed to become more popular with less issuance in the primary market," said one convertible trader away from the Merrill Lynch desk. "Plus, the investor base is larger these days."

Merrill convertible analyst Tatyana Hube said as much, too, in the report. Merrill equity derivatives analysts Ben Bowler and Heiko Ebens also contributed to the report.

"Synthetic convertibles have been around for a long time, but until recently their issuance contributed only marginally to the overall convertible primary market. Before, issuing a synthetic was mainly driven by broker/dealers wanting to monetize their holdings of stock in various companies and secondarily by investors looking for a very specific exposure that the non-synthetic convertible market could not offer," Hube said.

"However, with the slowdown of traditional convertible new issuance, the synthetic convertible market witnessed a revival in 2004, when approximately 200-plus deals were priced for an estimated $3.5 billion in proceeds. Going into 2005, with the convertible primary market still looking lackluster, the synthetic convertible product remains very relevant and popular in the institutional marketplace."

Synthetics old and new

There are lots of these issues that currently trade on the New York Stock Exchange, as well as many others that were issued in private placements. They are created in an offering by an investment bank, exchangeable into shares of another underlying stock in a company that may or may not be a convertible issuer.

These issues also can be custom-made by a broker/dealer, and created even without a broker/dealer, except for the necessary stock borrow underlying the convertible.

"Such security has the credit strength of the issues, generally a major bank, while providing exposure to stock price volatility, and therefore optionality, of another company's common stock" that might not be available through a standard convertible, Hube said.

Typically, she said, convertible bonds offer a current income advantage over the underlying equity on the magnitude of 1% to 4%, and that usually will meet minimum current return requirements for participation by certain institutions.

Present conditions ripe

Market conditions are ripe for a look at these types of securities, she added.

In addition to a low supply of traditional convertibles, the analyst said rationale for the synthetic product is also supported by other market conditions, such as tight credit spreads, and various structural factors like the prevailing busted nature of the standard convertible market, which severely limits the equity sensitivity of a convertible.

"Current low volatility and low interest rate environment continues to be favorable for issuing and investing in synthetic convertible structures," Hube said. Plus, "Complexity and parameters are determined by the customer's investment needs and risk requirements."

A particularly appealing feature, she said, is that these can broaden the range of companies in a portfolio, thus limiting risk or exposure. Equity investors with a minimum yield requirement can invest in a company through the convertibles as opposed to the common stock. Bond investors who cannot own equity can gain access to the company through a convertible.

Furthermore, synthetic convertibles further open the scope to companies outside the standard universe of the convertible market.

Latest synthetic spin

In addition to basic synthetic structures described above, Hube said investors have been proactive in asking for, and broker/dealers accommodative in adding, various simple and complex features to custom synthetic structures that provide further benefits and flexibility to the holders.

Knock-in puts for mandatories have been added to provide downside protection not present in traditional mandatory structures. Floating-rate coupons also have emerged to address the current low interest rate environment.

Dividend protection has been added, too, mirroring the trend in standard new convertible issues.

Savvy investors also have been able to require the ability to combine convertibles with credit default swaps: This feature allows investors to increase credit risk improving the yield on a synthetic convertible, or to decrease credit risk gaining even more downside protection.

These come at a cost, though.

"There is an inherent tradeoff between higher equity sensitivity (lower conversion premium) and higher income in convertible structures," Hube pointed out. "Features like dividend protection increase the value of a synthetic convertible to investors, while features like callability reduce the valuation of a convertible."

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