Merrill: Given richness of Goodyear converts, go long straight bonds, short stock

By Ronda Fears

Nashville, Jan. 11 - Given the richness of Goodyear Tire & Rubber Co.'s convertibles, Merrill Lynch & Co. analysts suggest a capital structure strategy going long the straight 7.857% bonds and short the stock by 1.8 shares. One could also short the $7.50 put, or go short the $15 call and long the $15 put.

At the heart of the matter is the run-up in Goodyear stock.

"The operating performance of Goodyear improved in 2004, with increased demand from consumers, product introductions and market share gains helping to boost results," said Merrill analysts in a report Tuesday. "During the same period, the equity has appreciated some 86.5%, bonds of the company by about some 16% and a newly issued convertible up some 45%, despite being only being issued on June 28, 2004."

The rich valuation of the convertible makes it difficult to generate any significant return from a hedged perspective, the analysts said.

Goodyear stock too pricey

With the stock price viewed as too optimistic for Goodyear's results, which in turn has pushed up the convertibles, Merrill analysts Yaw Debrah, Marc Malloy and Jackie Weiss suggest a different strategy in the capital structure.

"At present, we believe that the equity and convertibles represent the richest part of the capital structure, with the bonds of the company offering greater value on a relative basis," the analysts said.

"Our strategies for taking advantage of the difference in pricing between the bond and equity markets involves giving up returns for upward moves in the stock in order to provide downside protection to the bonds.

"We believe this to be a reasonable strategy because we feel at present equity valuations are stretched on the upside, while on the downside risk is mitigated by improving market fundamentals, expectations of further progress in North American operations and fair liquidity."

Goodyear shares on Tuesday opened off 2 cents at $14.57.

Goodyear's 4% convertible due 2034 on Tuesday were quoted at 142.

Spreads reflect credit doubt

In addition, there is price disparity in trading levels for Goodyear's credit, the analysts said.

Goodyear's bonds are rated B3 with a negative outlook by Moody' Investors Service and B with a stable outlook by Standard & Poor's.

With Goodyear five-year credit default swap trading at 348 basis points over Libor, the Merrill analysts said the "spreads are reflecting the company's stressed financial profile, characterized by weak cash flow generation, low earnings, onerous debt service obligations and heavy under-funded employee benefit [pension] obligations."

The Merrill analysts said that if Goodyear results continue to improve as the stock suggests, there should be some tightening in the straight bonds, implying credit statistics more consistent with a B2/B rating as opposed to the present price levels that imply a sub-B3/B- rating.

Goodyear's 7.857% bonds due 2011 were trading roughly at 102.5.

Simple hedge would reap 6%

A simple hedge strategy of going long the straight bond and short 1.8 shares of stock could produce an average return of 6% between stock prices of $7 to $22, the Merrill analysts said. Breakeven on the downside is about $6.50 on the stock over the next year. Breakeven on the upside is $23. Beyond these levels, the strategy begins to incur losses.

If an investor believes that the stock price of Goodyear will remain in that range over the next year, the analysts noted that moderate amounts of leverage - between 1.5 and 2 times - could be applied to this position to increase positive returns.

The main risks to this strategy would be if Goodyear's stock rises by more than 50% over the next year or drops more than 52% - although the analysts pointed out that the performance of this strategy would exceed that of the straight bond - or that a sharp increase in interest rates causes bond prices to lose value over the next year. Interest rates could be hedged out, however.

Short put could add 1% to 7%

Adding a short January 2006 put with a strike at $7.50 to the long straight bond and short 1.8 shares of stock strategy would boost the average return by 1% to 7% in the stock range of $7 to $22, the analysts said.

The downside to this approach is that it increases losses moderately on the downside to 12.7% from 9.9% if the stock drops to $3.68 over the next year, the analysts said.

The main risks, though, are the same as the simple hedge strategy, regarding bigger moves in the stock along with interest rate risk, but the analysts also noted volatility risk. Since one would be short volatility in the option, they said, prior to the maturity of the option a sharp increase in Goodyear volatility could lead to losses if the trade is unwound prior to the expiry of the option.

To boost hedge flexibility

An investor could increase their flexibility in the hedge strategy, the Merrill analysts said, by going long the 7.857% bonds with a long position of 2.8 January 2006 puts at a $15 strike and short 1 January 2006 call with a $15 strike.

This, the analysts said, will shorten the breakeven time, making it possible to apply greater leverage to the strategy before losses are experienced at the breakeven points.

The disadvantage of this strategy is that it gives on average lower unleveraged returns at an average return of about 5% between stock prices of roughly $6 and $22, the analysts said.

Breakeven on the downside is $4.50 on the stock over the next year and $19 on the upside.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.