When Convertibles Become Difficult to Trade
In general, issues we deem to be illiquid (having a liquidity grade below 3) are usually convertibles with an outstanding dollar amount of less than $50 million. These issues normally command wide bid/ask spreads that make it difficult for investors to trade and realize the total returns that can be achieved on liquid convertibles. As a result, we recommend investors only focus on our Especially Recommended liquid issues, found on the third page of this section each week, and note that the illiquid issues that can be found on this list are at the request of subscribers and we do not include them in our performance calculations.
Still, even with liquid issues, from time to time anomalies will occur in convertible trading that appear to be too good to be true, for buyers, and a potential nightmare, for sellers. This situation can occur when the underlying stock, of a once liquid and call protected issue, has moved substantially to the point where it is trading on its conversion value (well above par) and institutional and individual hedgers have a difficult time borrowing the underlying stock to set up a short-sale hedge. In this scenario, the issue may trade at parity (conversion value) or even for parity less accrued. Technically, this should not happen. The remaining time value of the call protected warrant should justify some premium over parity being paid to sellers, otherwise they are giving away the warrant for nothing, plus, in some cases, the accrued interest due the sellers.
Why does this scenario occur?
Institutional hedgers usually trade convertibles in large lots of $500,000 or more. If the underlying stock is, or becomes, thinly traded, it may take days for the institution to borrow (shortsell) the stock to set up a hedge. When the convertible is deep-in-the-money (trading on its conversion value and well above par) the institution will be vulnerable to a decline in the stock until the hedge is fully set up. To decrease its risk, the hedger will often bid below par to gain a cushion against a correction in the stock. Usually, sellers, of an issue in this scenario, will be reluctant to accept anything less than par plus accrued, and as a result, liquidity in the issue will usually dry up and the issue will be hard to trade. Still, if holders are looking to get out, sometimes they will accept a price below par, because converting will result in the loss of any accrued interest, plus the stock price may drop before conversion takes place and the stock can be sold.
What To Do If You Are In This Situation
First of all, this type of situation for once liquid issues is rare because the dollar value trading volume on the underlying stocks usually are well in excess of $1 million per day, making them fairly easy to borrow. However, conditions can change, (i.e., the stock falls out of favor due to bad earnings, news, etc.), to the point where buyers will not meet sellers’ prices and the liquidity in the common diminishes, thereby restricting convertible hedgers.
Hold: If you like the prospects of the underlying common stock and are willing to accept the current yield of the issue and ride out minor ups and downs in the common’s price, hold the convertible until the call protection expires in expectation that the company will soon after call the issue (especially in the case of convertible bonds where forced conversion will improve the companies balance sheet.)
Wait For Your Price: Another choice for individual investors is that most institutions trade in large lots that are too big for the average individual investors. As a result, even though the issue appears to have become illiquid, by being patient and offering small lots at a price that is at parity, plus accrued and possibly a small premium, you may be able to pickup orders from individual investors who like the prospects of the underlying common stock.
Try To Short The Underlying Stock Yourself: Even though institutions are having a hard time borrowing the stock to set up a short-sale hedge, usually they are trying to accomplish the hedge on a large scale. Most individual investors, though, will have much smaller positions to hedge and may have an easier time borrowing the shares to sell short, locking in the current conversion value of the position. Recapping a short-sale transaction (see our lead article in the April 23, 2007 edition); brokerage houses usually have 3 types of accounts; cash, margin, and short. The convertible bonds or preferreds purchased will be held in a margin account. Even though these issues can be converted into common stock, to set up a short position you must borrow existing outstanding shares to short sell. This debit will be placed in a short account. Short sales are marked-to-market every night, whereas convertible bonds held may or may not be priced every night. If the stock underlying the short sale increases, your cash or margin account will be charged interest on the difference, the loss incurred (however, since the bond trades on conversion value, the bond or preferred should go up the same amount creating a wash). The reverse will also be true; if the stock goes down you will receive interest on your profit (the profit, though, should be offset by the loss in the convertible) until you buy back the short sale shares.
The purpose of this type of hedge is to lock in the current conversion value of the convertible and capture the yield advantage between the convertible and the common. The hedge can be maintained for as long as the hedger desires and be terminated by either buying the shares back, or in the case of getting out of a convertible, converting after a payment date, once the issue becomes callable or waiting until conversion is forced and then paying back the borrowed shares with the conversion shares. (Note, however, the lender of the shares can request the shares back, terminating the hedge prematurely and requiring the reestablishment of the hedge. But this is a rare occurrence.)
Write A Deep In-The-Money Call: If the underlying common in optionable, writing a long-term deep-in-the-money call that expires after the next payment date is an alternative to short selling. Since the option is deep-in-the-money it should offer downside protection against a pullback in the stock. The time premium buyers will likely pay may also allow you to get out of the convertible at a premium, depending on commission costs and the size of the position.
Accept What The Market Is Offering: Usually, this option should only be taken if holders absolutely want to get out of the position as soon as possible no matter the cost. Hopefully, holders will have realized a capital gain on the convertible that will ease the frustration of selling below parity.
Convertible buyers looking through our publication may from time to time see a call protected issue that appears to be trading below conversion value and view the issue as a screaming buy. In reality, most of these trades are between institution buyers involving large lots, but at times they can also be based on small lot trades. Still, for buyers, getting into the position may be a bargain, but, at the same time, you may have to pay the same penalty if you want to get out of the position quickly.
For sellers of these convertibles patience and persistence is often the key. While you may not be offered parity plus accrued today, tomorrow may be a different story. In addition, selling a large position by small lots at a time may attract individual investors, or setting up a short-sale hedge a little at a time may give individual investors an edge over institutional players who deal in large positions.