Floating-rate convertibles are effective hedge against rising rates, Deutsche says

By Peter Heap

New York, May 1 - Floating-rate convertibles do provide an effective hedge against rising interest rates, according to a new study by Deutsche Bank Securities Inc. analysts Jeremy Howard, Jonathan Cohen and Robert Barron.

Indeed, their analysis shows that the recently issued Lehman Brothers convertible floater due 2022 actually increases in value as rates rise, gaining 0.10 for a 50 basis point interest rate increase, while a regular fixed-rate convertible would lose 0.79 point.

The Deutsche analysts noted that floating-rate convertibles have recently reappeared in response to investor concerns about rising interest rates. So far three deals have been issued in the U.S.: one from Merrill Lynch & Co., the Lehman offering and Waste Connections, Inc. The Lehman and Waste Connections deals have a floating-rate coupon while the Merrill has a zero-coupon and a floating yield to put or redemption.

To model the behavior of these securities, the Deutsche analysts used a simplified method which they believe offers a good approximation. They derived the individual future coupon payments from the yield curve, converted them into an equivalent fixed coupon and then applied standard convertible models.

For the future three-month Libor rates (or six-month rates), the analysts noted that the difference between two points on the yield curve implies a future short-term rate between those two points. As a short cut, they used Bloomberg function FWCV.

As an indicator of the sharp future rise in interest rates incorporated in the yield curve, the analysts noted that by late 2005 three-month Libor is anticipated to be nearly 6% - although they pointed out that would be the same as the rate that applied for most of the 1990s.

To convert the resulting stream of coupons to a fixed rate, swap rates are used. The Deutsche analysts said their preferred method is to use the fixed coupon which gives the same bond floor as the floating coupon. A simpler method is to use the Bloomberg swap calculator BCSW.

For Waste Connections, the first method gave 5.575%, the second 5.59%, using an expected life of 5.68 years.

A similar technique can be used for the floating put/redemption structure used on the Merrill deal. In this case, the analysts noted, the hedge is not so good although the convertible only loses 0.15 points for a 50 basis points increase in rates versus a 1.19 point loss for a comparable fixed-rate 0% convertible.

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