Floating-rate convertibles still attractive despite peaking interest rates, says J Giordano's Berkman

By Kenneth Lim

Boston, Oct. 13 - Floating-rate convertibles continue to offer real investment values and coupons that are unusually high for investment-grade paper despite expectations of a peak in the interest rate cycle, says J Giordano Securities senior vice president and convertible securities analyst Paul Berkman.

Many of the current outstanding floating-rate convertibles were issued about three years ago when interest rates were low, Berkman wrote in a research note. Rising stock prices and two years of rate hikes by the Federal Reserve turned those convertibles into attractive investments, but there is now a sense that short-term interest rates may be at a peak.

Berkman explained that floating-rate convertibles were similar to rolling investments in three-month Treasury bills, in that the investment value of the floater remains essentially unchanged regardless of which direction interest rates move.

Regardless of a floating-rate convertible's years to maturity or put, the appropriate risk-free yield is the three-month rate for a floater with quarterly resets, Berkman said.

"The net effect is that floating-rate convertibles offer investment values that are real, relatively insensitive to interest rate fluctuations, and relatively high in relation to par," Berkman wrote.

Floating convertibles will not benefit as much as fixed bonds if interested rates fall, but they will also not be hurt if rates rise. For floaters that have put options within the next two years, the narrow interest rate parings that are widely expected should not change the fact that their coupon rates are "unusually high within the universe of investment-grade convertibles," Berkman said.

Market expectations of lower interest rates may take a bite out of the market price of floating-rate convertibles, but if those securities are coming due within the next two years, the impact should not be very large, Berkman said.

"The prospect of declining rates should not deter the purchase of a floating-rate convertible," Berkman wrote.

Berkman highlighted five floating-rate convertibles that he reckoned are still attractive. Those are Lockheed Martin Corp.'s three-month Libor minus 25 basis points convertible due 2033, Prudential Financial Inc.'s three-month Libor minus 276 bps due 2035, SLM Corp.'s three-month Libor minus 5 bps due 2035, Wells Fargo and Co.'s three-month Libor minus 25 bps due 2033 and Wyeth's six-month Libor minus 50 bps due 2024. All have puts within three years.

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