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Derivatives

Investors Look For Synthetic Alternatives To Convertible Bonds

Investors globally are starting to buy synthetic convertible bonds for the first time because corporate issuance of the cash instruments has fallen by around a third year-on-year. Tom Wills, derivatives specialist at Morley Fund Management in London, said it bought its first synthetic convertibles in the past couple of months for a USD270 million long-only convertible fund. And derivatives houses, including Deutsche Bank, Citigroup, UBS Warburg and Société Générale, are starting to push the product.

A synthetic convertible is typically composed of a zero-coupon bond and an embedded equity call option. Although there is global interest for these synthetic structures, the largest market is the U.S. because that is where most convertible bond investors are based, according to Jeremy Howard, head of convertible research at Deutsche Bank in New York.

"There has been a lot of interest on the buyside for [synthetic convertibles] because the convertibles market is almost completely busted--there is a lot of money chasing very little issuance," said Pavel Verzhbitsky, convertibles research analyst at Lehman Brothers in London. Banks are seizing the opportunity to offer these products because real-money investors are willing to pay higher premiums than leveraged accounts for the bonds, he said. Convertible issuance has fallen steeply, with about EUR4.4 billion (USD4.851 billion) sold in Europe and the first quarter of this year, compared with EUR7.2 billion in the same period last year, according to Douglas Decker, director and head of equity-linked origination at Barclays Capital in London. In the U.S., USD20 billion was issued in the first quarter of 2003, compared with USD28.4 billion in the same period of 2002.

Wills said he is interested in these instruments because of the lack of supply of corporate-issued instruments and the fact that many converts are now expiring. Several deals issued by telecom and technology companies in the late 90s to raise funding when their equity prices were low are now close to expiry. Wills added that he is looking for bonds with high deltas.

One banker said that buying synthetic convertibles can also allow investors to broaden the diversity of their portfolios since they can purchase credit names that do not typically issue convertible debt. In general, convertible issuance is concentrated in emerging growth sectors, such as telecoms, he added.

Deutsche Bank's Howard said investors are looking for synthetic deals with deltas between 60-70%, whereas recent corporate deals have deltas around 50%. A higher delta means the option price is more sensitive to changes in the share price. Barclays' Decker added that the average outstanding convertible that an investor might hold currently has a delta of 20% or lower.

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