Deutsche urges caution on 0% convertibles vulnerable to cash call after Costco announcement

By Ronda Fears

Nashville, March 10 - Costco Wholesale Corp.'s potential cash call on its 0% convertible due 2017 shook up the convertible market, and Deutsche Bank Securities Inc. convertible analysts said there are others vulnerable to such a situation.

The prospect of a cash call makes these issues appear to be trading expensive, the analysts said.

Specifically, the analysts advised caution regarding Johnson & Johnson's 0% due 2020, Whole Foods Market's 0% due 2018 and Anadarko Petroleum Corp.'s 0% due 2020.

On its quarterly earnings call last week, Costco management indicated it would consider calling the convertible for cash if parity declined below the call price.

"Costco's comments about its convertible have shaken the market's belief that many investment-grade 0% convertibles would never be called," said Deutsche analysts Jeremy Howard, Jonathan Cohen and Robert Barron in the report.

This would appear to put the Costco convertible at risk with the stock much below $26.67 - the stock price where parity equals accreted value, the analysts said.

"We conclude that to command its current premium of around 5 points above parity, investors are placing a relatively low probability on an efficient cash call," the analysts said.

"Either that, or they are speculating on the possibility of a sizable gap in the stock to the downside. Having read and re-read the transcript of the company's comments relating to the possibility of a call, we believe that the bond's current valuation remains stretched."

Costco's stance is interesting because it does seem to vindicate many investors' belief that these convertibles would not be called efficiently for conversion, the analysts said.

But on the flip side, it has highlighted the risk that with interest rates as low as they are now, that some bonds could be vulnerable to a call and refinanced for cash.

"Unfortunately, either scenario produces the same result," the analysts said.

A callable bond that investors know will be called efficiently for conversion will only trade at parity plus the call announcement period option as soon as it is in the money.

But conversely, a bond that investors know will be called for cash only will also only trade at the higher of parity and the call price plus the call announcement period option.

"If there is no possibility of premium expansion on the downside, there can be no premium on an in-the-money bond in the absence of a running income advantage," the analysts said.

"For this reason we would also urge caution on other zero coupon callable bonds where the accretion rate (yield) is close to the level where the company could refinance in the straight market."

The analysts noted the Johnson & Johnson 0% due 2020, callable in July, is trading at a 3% yield.

The Whole Foods 0% due 2018, callable in March, is at a 5% yield.

And, the Anadarko 0% due 2020, callable in March, is at a 3.5% yield.

© 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.