By Ronda Fears
Nashville, Jan. 24 - While the credit spread curve for STMicroelectronics is currently inverted, a refinancing of its convertibles could reverse it, a situation that creates a trade opportunity, according to therein Deutsche Bank Securities convertible analysts in London.
"The STM credit spread curve is currently inverted. Investors can pick up five-year protection for less than the cost of two-year protection. This creates an opportunity for investors to play the curve," said analysts Michael O'Connor and Clodagh Muldoon in a report Friday.
"We believe this distortion is caused by the demand for protection from convertible investors, seeking to hedge the two convertibles [the 2010s and 2009s] to their respective put dates. Consequently the two-year spread simply looks too high.
"We believe convertible investors can take advantage of this by buying the STM '10s and hedging their position with five-year CDS protection.
"This will give investors full protection to the put date of the convertible for a lower cost than the yield of the protection that they have bought. Investors are left with a residual forward CDS starting at the put date, and expiring five years from inception (i.e. roughly a three-year CDS starting in approximately two years).
"Netting the yield of the convertible against the five-year CDS allows the price of the three-year forward CDS to be calculated. If STM's credit spread stays above this level, then investors will profit from the trade."
STM has a 0% convertible due 2009 that is putable in September 2004 and a 0% convertible due 2010 that is putable in January 2005. The total put obligations would amount to $2.21 billion, or $2.66 billion at maturity.
The 2010 convert ranks senior to the 2009 issue and is deliverable against the default swap. The five-year default swap is currently trading at a lower spread to the implied credit spread of the convert, saving investors 36 basis points a year, the analysts said.
"Having calculated the breakeven, investors would only be exposed to the downside if three-year CDSs traded tighter than 80.85 bps after the put date. The five-year CDS has not traded tighter than 90 bps over the last two years," the analysts said.
"The STM curve is only inverted because of the demand for protection created by the convertibles. In our view it is highly probable that STM will look to refinance its convertibles by coming back to either the fixed income or convertible markets. In either of these events the curve would disinvert, generating profits for the trade."
STM has an enviable balance sheet with a cash position of $2.6 billion and a net debt position of $400 million, but the analysts said it is doubtful the company will repay the bonds out of its cash balances as it would greatly reduce short-term liquidity.
"We feel that it is more likely that it will come to the market to refinance these issues," the analysts said.
"If STM chose to refinance by issuing debt (convertible or straight), thereby extending its debt maturity profile, it is likely that we would see its spread over curve, which is currently inverted revert to that of a typical yield curve.
"The shorter-dated CDSs would come in and the longer dated five-year CDS would widen, reflecting the fact that the new funds raised had eliminated any risk associated with the repayment of the 2009 and 2010 issues, while the new longer-dated replacement issues would cause a widening further down the yield curve.
"Indeed, even if STM refinances the convertibles using its cash balances, this would stretch the balance sheet, causing longer-dated spreads to widen."
The 2010 issue is the best way to play the situation, the analysts said.
With two years to run until its put date, investors can realize the value presented by the current curve anomaly by picking up five-year default swap protection against their long convertible position.
The 2010 convert is currently offered at 75.35, which equates to a spread of 146 basis points over swaps to the put, the analysts said, noting that factoring in the minimal value of the residual optionality increases the implied spread slightly to 153 basis points.
STMicroelectronics 0% convertible due 2010
| Price (ask): | 75.35
|
| Redemption: | 100
|
| Parity: | 17.87
|
| Premium: | 321.72%
|
| Yield to maturity: | 3.656%
|
| Bond floor: | 75.14
|
| Yield to put: | 3.376%
|
| Call: | November 2003 at accreted value
|
| Put: | Jan. 17, 2005 at 80.515
|
| Real/implied spread: | 146 basis points/153 basis points
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