Merrill analyst finds value in switching between multiple convertibles of Mercury, Inco, Tyco, Charter

By Ronda Fears

Nashville, May 25 - The availability of multiple convertibles by a single issuer has created some opportunity to capture value for investors by switching out of one and into another, said Merrill Lynch convertible analyst Marc Malloy. The phenomena of issuers returning to the convertible market is at an all-time high, he noted, with serial converts rising to 348 totaling $157 billion currently from 145 totaling $30 billion at year-end 1996.

Specifically, Malloy recommended in a report Tuesday, based on relative value, Mercury Interactive Corp.'s 0% convertible issue over the 4.75% issue, Inco Ltd.'s 1% convertibles over the 0% issue, Tyco International Ltd.'s 3.125% issue over the 2.75% convertibles and Charter Communications Inc.'s 5.75% over the 4.75% issue.

Savvy investors can swap between issues within a company to capitalize on relative valuation changes, he said, and for companies that have tapped the convertible market using different structures, investors can adjust their holdings to gain equity or credit exposure.

"As demand outpaces new issuance, the market has become increasingly richer," Malloy said in the report. "With the equity markets giving mixed signals and not much upside potential on the credit or yield side of the equation, investors should be increasing their focus on relative value ideas."

Mercury Interactive

Mercury Interactive has two convertibles outstanding - an equity sensitive zero due May 2008 and a busted 4.75% due July 1, 2007 that is currently callable at 102.714.

Using a credit spread of 277 basis points over the five-year Treasury and an equity volatility of 35%, Malloy estimates the 4.75s are trading 1.3% rich versus the zeros trading 0.21% cheap when applying the same volatility and credit spread.

He noted, too, that the credit assumptions for the 4.75s might seem generous considering the 4.75s are subordinated notes and the zeros are senior obligations, but the same spread was used for the 4.75s by virtue of the earlier maturity.

The zeros look even more attractive when taking into account a favorable outlook on the underlying equity by Merrill stock analyst Jason Maynard.

Inco

Inco has three convertibles outstanding with a combined market value of about $1 billion. Of the three, the 1s and the zeros are most comparable because they are both senior unsecured obligations and offer at least two years of call protection. The 3.5s are subordinated obligations and have a soft call at $32.52.

Comparing the 1s and the zeros, Malloy said the 1s are more attractive due to the call protection, dividend protection, valuation and yield. The 1s are callable March 14, 2010, whereas the zeros are callable March 29, 2007 and provide dividend protection for stock dividends greater than 5%.

Using the same equity volatility and spread assumptions - 42% volatility and a credit spread of 155 basis points over the five-year Treasury - Malloy estimates the 1s are trading 5.2% cheap compared to 2.0% cheap for the zeros. Also, the 1s provide marginally higher current yield of 0.86% versus none for the zeros.

Both the 1s and the zeros provide equity exposure with deltas of 0.68 and 0.75, respectively, he added, and Merrill equity analyst Daniel Roling has a buy rating on the stock with a $30.92 target.

Tyco

Tyco is the second-largest issuer of convertibles in the United States with the combined market value of its convertibles at $6.2 billion, accounting for roughly 3% of the Merrill Lynch convertible index. Tyco's two largest issues are very similar in structure, which makes comparisons relatively straightforward.

Comparing Tyco's 3.125s versus the 2.75s, Malloy said the 3.125s are more attractive due to yield, valuation and call protection. The 3.125s have a current yield of 2.1% and yield to maturity of 0.5%, which compares favorably to the current yield offered on the 2.75s of 2.0% and yield to maturity of 0.1%.

Using identical credit spread and volatility assumptions, the analyst estimated that the 3.125s are trading 0.62% cheap, while the 2.75s are trading 0.2% rich. Also, the 3.125s provide two additional years of call protection.

Charter Communications

Charter has two convertibles outstanding - both very much busted and trade solely on investment value.

The 5.75s are due Oct. 15, 2005 and have a yield to maturity of 9.6% with an implied spread over the five-year Treasury of 760 basis points. The 4.75s mature on June 1, 2006 and have a yield to maturity of 9.2% with an implied spread of 662 basis points.

Presumably, the 4.75s are trading richer due to their lower dollar price, Malloy said.

Assuming Merrill's pricing is indicative of the market rates and Charter is not offering sweeteners to holders of the 4.75s, Malloy said the 5.75s are more attractive despite the slightly higher dollar price because they rank pari pasu with the 4.75s, offering better yield, and mature eight months earlier.

Charter is a complex credit and the converts are subordinated obligations, Malloy stressed, thus, investors should be very comfortable with Charter's fundamentals before investing in these convertibles.

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