(R) Let's look aside from the common equity for a while

There is a handful of cherries in the macro-financial cocktail which leaves the investors with a bitter taste of uncertainty and risk: stagflationary US economy, energy prices hike, impoverishing consumers, inflationary EU, slowing sales and last but not least lack of confidence on the markets. The escalating risk aversion, driven by the crisis, I believe, is taking us to a rationality-reversion point where the fear balances the greed. The sobering of the investors has come as a natural consequence of the US stagflation, in parallel with the global financial and capital markets crisis and resulted in a push for less risky investments … at least for now.

For a better understanding of the global markets’ standing we need to get back to its (i) genesis, which lies within the high risk tolerance of the financial institutions and the real estate and property greed of the US consumers; and (ii) to the contributors the structured finance desks, the mortgage brokers, the credit rating agencies and last but not least the regulatory institutions. The tremendous need for fundraising has motivated the spinning of a large investment network. Every node of the net was aware of the risks and was confident in its ability to transfer or mitigate those risks. Fairly quickly it turned out to be a misunderstanding of the risk the way we know it, resulting in the lay off of 70,000 to 100,000 highly-skilled financial professionals, and some $ 280 billion already written down⁽¹⁾, up to $ 1 trillion losses expected, leave alone the impacts on insurance companies, monoline insurers, home owners, financial system health, etc.

Bearing in mind the ski-rocketing volatility and the diminishing confidence in the global bond and equity markets, we face a harsh risk-return dilemma. By harnessing the volatility through the embedded options of the (i) convertible bonds, investors could lean on expectations of a shorter recession cycle and approaching economic growth in order to abandon the fixed-income and embrace the potential in the equity growth or (ii) stick to the preferred stocks for having their “fixed” piece of the pie and forgetting about the rising fundamental risks, at least temporarily.

Some of the reasons why investors and issuers would prefer convertible bonds and preferred shares in the currently rough seas are their anchor mechanisms.

The convertible bonds appeal to the issuing company by allowing for lower interest, which is typically tax deductible, requires no cash to be exchanged for and postpones equity dilution for certain time. All this advantages multiply their role in periods of widening spreads and flight to quality.

At the current rates the issuance of a convertible bond would save some 300-400 basis points in coupon payments. ⁽²⁾

For the investors the convertibles provide for an investment timing option to await a better share price performance, a typically higher coupon yield than dividend yield, captured significant downside potential and value insurance against rate shifts.

In the last quarter of 2007 U.S. and European convertible notes rose 25 percent from the same period in 2006. The securities provided a refuge for the investors from the subprime mortgage contagion that pushed corporate borrowing costs to a five-year high. ⁽³⁾

What would turn the preferred shares financially attractive for the issuing company are their lower interests, usually with an option for accumulating cash outflows during hard times, known cash outflows ahead of time, lower leverage and usually an embedded call option. Furthermore, the preferred shares, which qualify for a Tier 1 capital, offer additional capital adequacy for the banks and a balance sheet repair after the credit losses writedowns.

The difficult environment for raising capital has lead to many companies issuing preferred stocks. The issuing companies have had to offer attractive terms to sell these larger than previous offerings, this has been especially true in the financial sector where many new offerings have high dividend rate and some include options to convert to common stocks. Recent banks’ preferred issues such as the Bank of America’s, $6 billion, Merrill Lynch’s $ 2.7 billion Wachovia’s $3.5 billion and Lehman’s $4 billion, just confirm the shift of preferences of the undercapitalized banking sector. ⁽⁴⁾

For the buy side, preferred stocks usually offer investment timing option to await a better common equity price performance, captured to certain extend downside potential, known cash inflow ahead of time and quite often the earned dividend income would qualify for tax credit.

Benchmarking the average fixed rate payments of the recent preferred stock issues, around 8.0%, to the long-term, broad index return of 10.5% we could not overlook the 250 basis points discount for the issuers. On the other side if we take into account the trailing thirty-six months of the same broad index performance, we end up with 5.5% annualized return which compared to the 8.0% average preferred return is some 250 basis points less appealing. Despite that, the average investor is happy to claim the lower payment in exchange for a guaranteed floor of the return and the upside potential option. At the same time the average issuer is content with the lower than common equity expected payouts, by offering an option to redeem its investors in better times.

Evidence of the tilt towards convertible bonds and preferred stocks on the capital markets could be found in the trends for the past several years of the issuance of those securities, while compared to the straight corporate bonds and the common equity, respectively.

A review of the US Securities Industry and Financial Markets Association data reveals a solid lead of the convertible bonds which exhibit annualized 2005-2007 new issues growth of about 80% ⁽⁵⁾*, while the straight corporate bonds would just record some 27% for the same period. Though not so strongly diverted, but still significantly apart are the growth rates of the preferred stocks hitting 13.5% new issues annualized growth, when compared to the 7% of the new common equity issues for 2005-2007 period. ⁽⁵⁾ **

Attempting to look a bit further in time, I strongly believe that in the coming six to twelve months few would see continuously rising common stock prices, while real margins are being squeezed by inflation, sales are turning downwards and interest rates are probably rebounding. This by the way has already been confirmed by the preliminary second-quarter US and European reports. Even fewer would dare to boost the derivatives and the structured products’ mint press, for they would simply exacerbate the current market environment. Therefore, the current lower-risk-modest-return market frame offers a growing opportunity for the option-embedded, risk-absorbing securities such as the convertible bonds and the preferred stocks.

⁽¹⁾ www.pr-inside.com

⁽²⁾ www.reuters.com

⁽³⁾ www.bloomberg.com

⁽⁴⁾ www.en.wikipedia.org

⁽⁵⁾ www.sifma.org

* data by Securities Industry and Financial Markets Association (SIFMA) and Reuters

** Nov & Dec 2007 data estimates // all growth data represents nominal USD volume growth