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Playing the Linear Technology Convertible Call


The stock price is rising today. Is this the best time to buy?

In the good old days, when a company announced that it was calling a convertible bond and the stock was above the conversion price, the results were reasonably predictable. Typically, most of the bonds had already moved from outright (unhedged) investors to hedge funds, which then established appropriate short positions. Outright funds that had not yet sold would typically sell soon after the call announcement to dealers, who would then short stock to hedge themselves before transferring the entire bond/hedge package to convertible-arbitrage hedge funds. The net effect would be a few days of selling pressure. Ultimately, the hedge funds would convert the bonds, and the stock they obtained would be delivered against the short hedge.

But the game has changed. Most convertible bonds now follow a regime known as "net share settlement," under which issuers repay the bonds' issue price (the first 100 cents on the dollar) in cash and only deliver shares for the gain. Sometimes they even pay the gain in cash.  Companies do this because it allows them to avoid having to account for a full conversion of the bonds when they calculate fully diluted earnings per share.

But this causes called bonds to have very different results than they used to. A big case in point is Linear Technology (NASDAQ:LLTC), whose stock is rising today after the company called its $845 million convertible bond yesterday.

Here's what happens: To figure out how much stock Linear Technology has to pay converting bondholders, the company will look to a 20-day trading period that started today. The average price realized over that period will determine how many shares bondholders get. Let's say the average price turns out to be $50. The bond is convertible into 24.5821 shares -- this would mean a conversion value of $1229.11, or 122.91% in bond-speak. Bondholders would get $100 in cash and $22.91, just under a fifth of the total value, in stock. This means that hedge funds that came into today short all the underlying shares against their bonds actually will need to cover about 80% of their short over the next 20 days.

As you can see, there's a bit of guesswork and gaming involved. Some hedge funds may choose to buy back more of the stock early (some, in fact, may have started before yesterday's call). Others do it by the book and build a spreadsheet telling them how much to buy (roughly 4% per day). If the stock rises, hedgers will get more shares, so they'll need to buy back somewhat less of the hedge.

How much stock is involved? Well, it depends on how the bonds were owned coming into the call. When the stock is far above the conversion price, you can assume virtually all the bonds are in arbitrageur hands. LLTC is a bit trickier -- the bonds closed yesterday at about 120, so it's likely that a decent number of outright investors still owned them. Let's estimate that 75% of the bonds were hedged and 25% were outright coming into today. That's about $630 million hedged and $215 million outright. Since the bonds are trading around conversion value, we can speak about bond and stock values interchangeably.

If hedgers need to cover about 80% of their shares, that comes out to about $500 million of stock to buy over the 20 trading days beginning today, or about $25 million (roughly half a million shares) daily. This is on the order of a quarter of average daily volume -- enough to give a meaningful upward bias to the stock.

This will be only marginally offset by selling pressure from outrights transferring their positions to the hedge community, both because the majority of the bond will be paid in cash (barring a huge stock spike in the next few weeks) and because we have assumed that most of the bonds have already been hedged. Since a $50 average price means each $1 million bonds creates $229,100 in shares, our assumption of about $215 million outright means about $50 million in stock selling -- only about one-tenth of the shares the hedgers need to cover.

If our numbers are approximately right, this means that LLTC shares will be better to buy from now through April 29, which should be the last day of the averaging period (allowing for the Good Friday holiday). Again, some hedgers will doubtless try to game the system at their own risk. But if you've been looking for a lower entry point into LLTC, it's likely you'll have to sit out April.
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