o Convertible Bonds have suffered more than any other o Convertible Bonds should now not suffer more than

CB Focus Convertible Bond Research November 17th 2008 Convertible Bonds: Negative correlation between the liquidity crisis and CBs valuation No long...
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CB Focus Convertible Bond Research November 17th 2008

Convertible Bonds: Negative correlation between the liquidity crisis and CBs valuation

No longer the House of Pain. o Convertible Bonds have suffered more than any other

assets classes creating historical arbitrage opportunities. Convertible Bonds are now naked. Call-options are free. o Convertible Bonds should now not suffer more than

other financial assets. Cash is coming from issuers, through redemptions and buy-backs. Opportunistic asset managers are chasing yields. The funding cost, Achilles heel of Convertible Arbitrage strategy, is now normalizing thanks to coordinated Central Banks action. Authors: Benoît Le Pape, Convertible Bonds Analyst 33 1 41 89 44 09 Raphael Hasson, CB & Flow Derivatives Analyst

o Cash rich investors are coming back to the market, but

they are not buying equities, they are buying preferred shares, with high coupons in most cases and with warrants attached sometimes.

33 1 41 89 66 79 Thierry Cantet, Head of Equity Derivatives Research 33 1 41 89 44 38

o It is now time to make an arbitrage between asset

classes: 

Equity-linked

instead

of

Equity:

the

“Buffet Choice”. Convertible Bonds instead of Straight

E-mail : [email protected]



Calyon CB Research on Bloomberg: CACC

Bonds: Call-options for free.

Disclosures are available on www.cheuvreux.com Calyon is regulated by AMF “Autorité des Marchés Financiers”

CB Focus

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11/17/2008

B Daily News

Index & Recommendations  Understanding the Fall.

Page 3

 Absence of “downside protection”: disappeared bond floors.

Page 4

 The Fall of key market players.

Page 6

 The funding issue: Achilles heel of Convertible Arbitrage strategy.

Page 7

 The timing issue: Have we reached the bottom on CBs valuation?

Page 9

 No longer the Black Sheep of Financial Assets.

Page 11

 Time to make asset classes arbitrage.

Page 12

o Equity or Equity-linked ? “The Buffet Choice”.

Page 12

o Convertible Bonds instead of Straight Bonds: call-options for free.

Page 14

o Cash versus CDS: the Base Spread based Arbitrage.

Page 17

o Risk arbitrage: Play the change of control put.

Page 18

We have screened our universe via 4 arbitrage strategies (see 12 page to 18). We recommend the following Convertible Bonds that match at least 2 arbitrage strategies:

 TUI 2.75% 2012  3I group 3.625% 2011  Acergy 2.25% 2013  Alcatel-Lucent 4.75% 2011  Finmeccanica / STM 0.375% 2010  International Power 4.75% 2015  Michelin 0% 2017  Valeo 2.375% 2011 All figures as of 13th of November, 2008.

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Understanding the Fall:

The month of October has been quite paradoxical for Convertible Bonds. On the one hand, the asset class and its flagship strategy, the Convertible Arbitrage, have posted disastrous performances. Convertible Bonds Funds have been the victims of the combined collapse of their assets valuations (fall of equities and explosion of credit spreads) and financing (Convertible Arbitrage based its excess returns on massive leverage). The stress among market players has reached such a high point, that many have raised the question if the asset class would lose its own existence. Having seen Convertible Bonds reacting like falling knifes, one could ask if this asset class could maintain a structurally low correlation with other asset classes by offering the well-know “downside protection” through its “bond floor”. But, on the other hand, the risk-reward offered by Convertible Bonds has been chased by cash rich investors (Warren Buffet, sovereign funds...). These non-levered investors are coming back to the market, but they are not buying equities, they are buying preferred shares, with high coupons in most cases and with warrants attached sometimes. States on both sides of the Atlantic are acting the same way to save their banking systems and protect taxpayer’s interests… But, it is difficult for institutional investors to have access to these kinds of investments (private placement most of the time). Before the beginning of the Sub-prime crisis, Convertible Bonds were commonly viewed as an expensive asset class characterized by structural volatility premium over equity options. Since the beginning of 2008, this is not the case anymore. Implied volatility has collapsed and an enhanced correlation between equity and credit is now synonym of non-resilient bond floors.

Chart 1 From a structural volatility premium to zero-valued call-options

Source Calyon.

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Chart 2 Towards a High Yield Universe

Source Calyon.

Absence of “downside protection”: disappeared bond floors

Many market players have been shocked by sliding bond floors. During the Fall of September-October, many Convertible Bonds have reacted like delta-one products, while their theoretical deltas barely existed. Chart 3 On November 2008, the CB Index now sticks to its “theoretical delta-driven” performance

Source Calyon.

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11/17/2008

Chart 4 The Equity part on an “equity-linked product”

Source Calyon.

Chart 5 Before July 2007, an “over-performance” leading to a structural volatility premium

Source Calyon.

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Chart 6 After July 2007, forget about the Conversion, CBs are just like illiquid bonds

Source Calyon.

The Fall of key market players:

On top of that the convertible asset class has been massively hurt by the re-composition of the financial universe made during the months of September and October.

Lehman Brothers More than other asset classes, Lehman bankruptcy has exposed the Convertible Bonds universe to a massive shock for 4 main reasons: • Lehman Bankruptcy has hurt not only CBs issued, but also CB-issuers. For example, the holding Siem Industries (issuer of the $ 275 M CB SIEM / SUBSEA 0% 2017) has lost $ 39.5 M when Lehman bankrupted, or 14% of funds raised thanks to the CB. Siem was indeed party to two stock lending agreements with Lehman. On 15 September 2008, Lehman had 4,68 M shares borrowed under the stock lending agreements (over a total of 16 M available for the purpose of on-lending to CB-holders). Fortunately, shares offered as a pledge to secure Bondholders’ recovery were not subject to the stock lending agreements with Lehman. • Lehman Bankruptcy has also hurt holders of Synthetic Convertible Bonds issued by Lehman bought to face a decreasing primary market in Europe since 2004. European Funds were for example exposed to the € 200M synthetic Convertible Bond exchangeable in SAP Shares maturing in march 2009. • Lehman Bankruptcy led also to the liquidation of assets offered by Lehman as collateral. Most of these assets were convertible bonds…. • Finally, Lehman Bankruptcy tolls the bell for many proprietary trading desks.

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Fortis Convertible Bonds holders were also massively hurt by Fortis split. Many outright CBs funds that were constrained by rating criteria were indeed overexposed to Perpetual CBs issued by Fortis (€ 3 bn Perpetual Fortis Cashes Price & € 1.25 bn Perpetual Fortis Fresh Price).

Chart 7 € 4.25 bn Perpetual Fortis CBs impact on CB Implied Credit Spreads Index The acquisition of Fortis Bank (Belgium), issuer of the Cashes, by BNPP did not solve Convertible Bondholders’ problems as neither the Cashes nor the Fresh will be exchangeable into BNPP shares, and none of the coupons will be guaranteed by BNPP

Source Calyon.

The funding issue: Achilles heel of Convertible Arbitrage strategy.

Chart 8 Convertible Bonds Arbitrage strategy in the heart of the liquidity crisis & cash scarcity

Convertible Arbitrage strategy was one of the most “cash”-consuming alternative investment strategy and has been hurt by the dislocation of financial markets (ex: disconnection between cash and derivatives markets) and the explosion of the funding cost.

Source Calyon.

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CB Focus

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11/17/2008

Our European CB Index reported a variation of -20% YTD. We have selected CBs which have declined more than 2 times our CB Index. Among them, € 1.5 bn Immofinanz CBs are emblematic of an arbitrage made by the issuer between collateralized loan-holders & non-collateralized CB-holders. CB-holders have a structural short position on equity-credit correlation. Equity stories based on an increasing value of assets owned (ex: financial services, real estate, financing projects like vessels…) do not offer resilient bond floor, contrary to business model build on defensive and regular cash-flows (ex: concessions…). Chart 9 The worst performers European Convertible Bonds YTD

Source Calyon.

Chart 10 Convertible Arbitrage: the Black Sheep of alternative strategies during liquidity crisis

Source Bloomberg.

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The timing issue: Have we reached the bottom on CBs valuation?

The purpose of this paper is not to “predict” the end of the crisis, but to underline that Convertible Bonds Holder will no more suffer more than other financial assets holders.

Cash coming from CBs issuers

 Upcoming Redemptions: We should witness less forced seller in the month to come, as around € 3.6 bn European Convertible Bonds will be reimbursed before the end of the year (see table below).

 CBs Buy-backs: During the month of October, CBs issuers have declared that they have repurchased a part of their own CBs. This is a sign that CBs are clearly undervalued.

Chart 11 Some example of CBs buy-backs

On 10th October 2008, Siem Industries announced that it has repurchased $ 40 M of its SIEM / SUBSEA 0% 2017 Convertible Bond at an average price of 56.62%.

Source Bloomberg.

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On 27th October 2008, Punch Taverns announced that it has repurchased 24% of the outstanding nominal value of the 5% 2010 CB at an average price of 75%.

Source Bloomberg.

Cash coming from diversified & opportunistic asset managers We are seeing new actors coming on the convertible asset class: private banks, bond investors, monetary funds.

Cash coming from Central Banks The funding cost is normalizing thanks to interest rate cuts from Central banks, less risk aversion on banks. The US Libor and Euribor are normalizing (see charts below). The Euribor is cooling down, which should favor CB valuation and spreads.

Chart 12 Negative correlation between the liquidity crisis and CBs valuation

Source Calyon.

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Cash coming from Synthetic Convertible Bonds issuers Finally, we believe that forced selling may stop as outright investors have been able to sell synthetic Convertible Bonds. Liquidity was higher than on traditional Convertible Bonds and option volatility a lot more resilient than Convertible volatility.

No longer the Black Sheep of Financial Assets

Convertible Bonds have more suffered than any other assets classes creating historical arbitrage opportunities. Convertible Bonds are now naked, call-options are free. It is now time to make an arbitrage between equity and equity-linked products, between convertible and straight bond.

CA Cheuvreux Strategy team shares this view: “Our financial crisis represents the bursting of an enormous credit bubble. It has left us with massive overindebtedness, and not just in the household sector. The de-leveraging in credit markets has produced illiquidity and distressed pricing. Many convertible bonds are trading at prices that were thought to be impossible by pricing models. Equities may be cheap but many credit assets appear to be equally inexpensive. Moreover, credit may have advantages over equity on a risk-adjusted basis, if only due to the higher income flows accruing to credit. The greatest obstacle to a sustained recovery of equity valuation is a "crowding out" by distressed credit assets. Many convertible bonds are so cheap that it is theoretically possible to hedge the entire credit risk and retain a free option on the underlying equity. Many equity assets may now have an advantage over their physical counterparts. However, until the level of distress in the credit world begins to subside equities will remain cheap”.

Christopher Potts, CA Cheuvreux Economy and Strategy team, E-notes, “Shock me”, 10 November 2008

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Time to make asset classes arbitrage

Equity or Equity-linked ? “The Buffet Choice”

Traditionally, equity investors bought high delta CBs in order not to miss an expected recovery of the stock. We think “the great equity rally” won’t happen. In other words, if it happens, this won’t concern at first the equity market. We believe that equity-linked products allow investors to optimize their carry. In terms of carry (coupons vs. dividends), bond and loan holders are relatively better positioned than shareholders in the current environment. In the current environment, coupons are safer than dividends. Dividends expectations have been cut heavily by the market, even for big caps (ex: Utilities). The uncertainty on future dividend payments, even for non financial stocks, should last for some months.

Chart 13 SX5E dividend expectations Dividend expectations have been cut heavily on big caps especially for 2009 and 2010.

Source Calyon.

For equity investors, buying short CB paper (up to March 2010) offers more visibility than a direct equity investment. The investor is exposed to a default risk rather than an underperformance and/or a profit warning. The probability of default is much lower…

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Buying convertibles appears safer than buying equities for investors chasing yields.

Chart 14 Yield to Maturity of European CB’s: An attractive asset class.

Source Calyon.

The yield to maturity has exploded, especially since Lehman bankruptcy mid September. Yield to maturity levels are now well above equity dividend yields (around 6% for Eurostoxx).

Yield Advantage We have selected convertibles with a yield advantage above 1%. The yield advantage is the difference between the coupon yield of the CB and the dividend yield of the underlying. We have selected underlyings which have paid dividends in 2008. Our selection is made of stocks with dividends (this is a further security for bond holders as it may be cut), on which the CB coupon yield is higher. On all these convertibles, the yield to maturity (that takes into account the reimbursement payment if any) is high, above 10%. We have selected CBs that are non-callable before June 2009, so that asset managers could benefit from a yield advantage, without fearing to lose the conversion premium that they have paid.

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11/17/2008

Source Calyon for all datas except dividend yields which come from Bloomberg and CB ratings.

Convertible Bonds instead of Straight Bonds: call-options for free The goal of this paper is not to deliver a global message of massive confidence for Bonds. We are of course aware of the diffusion of the financial crisis to the real world and that credit related products will be hit by an increase of default rates. We want to highlight that some bonds have more suffered than their peers.

Chart 15 Diffusion of the financial & systemic crisis to the “Real” Economy

Source Bloomberg.

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CB Focus

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11/17/2008

Buying a convertible instead of a straight bond offers in many cases a free option. We recommend buying long maturity papers (2010 and longer). We have compared our CB universe with straight bonds when possible. Straight bonds need to have the same status, the same seniority, and a “similar” rating. In most cases the yield to maturity of the CB is well above the yield to maturity of straight bonds. This means that convertible option is priced at 0. Chart 16 YTM Difference between naked CB & Straight Bond

Source Calyon. NB: if the CB offers an option of early redemption to the bondholder, we compare the straight Bond YTM to the CB Yield to Put.

Chart 17 Convertible Bonds Status & Ratings

Source Calyon.

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CB Focus

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11/17/2008

Chart 18 Straight Bonds Status & Ratings

Source Bloomberg.

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CB Focus

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11/17/2008

Cash versus CDS: the Base Spread based Arbitrage

One other illustration that proves that the liquidity crisis has hurt the Convertible Bonds more than any other asset classes is the spread between the CDS and the Cash. Those markets seem now to be disconnected. This is the consequence of an increasing funding cost. We have highlighted the Convertible Bonds were the difference between the CDS and the CB implied credit spread obtained with an implied volatility of 10% (free call option) is the largest.

Source Calyon.

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CB Focus

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11/17/2008

Risk arbitrage: Play the change of control put

The universe of European Convertible Bonds offers an interesting speculative aspect through the Change of Control Put offered by many issuers. If an offer is made on the issuer, the bondholder will get the CB at par plus accrued interests. Even if the financing of M&A operations are more complex in the current environment, we believe that the Change of Control Put could be criteria to invest in a CB. Some CBs evolve in sectors where a consolidation is expected. In the Norwegian oil & services sector, the temptative of Subsea 7 to acquire during the third quarter Acergy control by buying $ 107 M of 2% Acergy 2013 CBs and $ 74.8 M of Shares & ADRs is a proof that special situation could be played through CBs. We have selected Convertible Bonds that offer a potential upside thanks to their change of control put of more than 40 %.

Source Calyon.

Please note that we do not take into account accrued interest for non-french CBs to calculate the potential upside. We have deleted from our selection CBs which have preferences shares that could stop an M&A operation (ex: Wereldhave 2.5% 2011, STM 0% 2016, IGD 2.25% 2012…), which are in a merger process (ex: Immofinanz 1.25% 2017 with Immoeast, Risanamento 1% 2014 with Limitless LLC…).

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CB Focus

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11/17/2008

Recommendation Matrix

To benefit from these historical arbitrage opportunities, we recommend investors to buy 8 Convertible Bonds that match at least 2 arbitrage strategies:  TUI 2.75% 2012  3I group 3.625% 2011  Acergy 2.25% 2013  Alcatel-Lucent 4.75% 2011  Finmeccanica / STM 0.375% 2010  International Power 4.75% 2015  Michelin 0% 2017  Valeo 2.375% 2011

Source Calyon.

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CB Focus

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11/17/2008

Appendix:

We have selected the European distressed CBs which price is below 60% of their nominal value:

Source Calyon.

We have selected the European High Yield CBs which YTM is above 20%:

Source Calyon.

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CB Focus

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11/17/2008

We have selected CBs maturing before the end of January 2010 that could offer an interesting YTM for Money Papers focused Funds:

Source Calyon.

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CB Focus

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Disclosure Applicable CA Cheuvreux disclosures for :  Acergy: E  Alcatel-Lucent: E  Finmeccanica: E  International Power: /  Michelin: E, G  STMICROELECTRONICS: E  TUI: E  Valeo: E, J  3 I Group: /

A

One or more companies in the Crédit Agricole S.A. group owned more than 1% of the total issued share capital of the Company as of the end of the second most recent month preceding the publication date of this report.

B

One or more companies in the Crédit Agricole S.A. group owned more than 5 % of the total issued share capital of the Company as of the end of the second most recent month preceding the publication date of this report.

C

The Company owned more than 5% of the total issued share capital of Crédit Agricole SA as of the end of the second most recent month preceding the publication date of this report.

D

One or more companies in the Crédit Agricole S.A. group held as of the end of the second most recent trading day, a net sales position higher than 1% of the total issued share capital of the Company.

E

The trading portfolio of one or more companies in the Crédit Agricole S.A. group contained shares of the Company as of the end of the second most recent trading day.

F

Crédit Agricole Cheuvreux and/or a company in the Crédit Agricole S.A. group is a market maker or a liquidity provider for the financial instruments of the Company.

G

Calyon and/or a company of the Crédit Agricole S.A. group has been involved within the last three years in a publicly disclosed offer of or on financial instruments of the Company.

H

Calyon and/or a company in the Crédit Agricole S.A. group has concluded or is party to a non confidential agreement relating to the provision of investment banking services (except publicly disclosed offers mentioned under G) to the Company during the past 12 months or that has given rise during the same period to the payment of compensation or to the promise to get a compensation paid.

I

This research has been communicated to the Company and following this communication, its conclusions has been amended before its dissemination.

J

A director or a board member of the Crédit Agricole S.A. group is an officer, director, or board member of the Company.

.

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