Convertible Bond Is Going To Break Really Bad

RPM International makes specialty chemicals, coatings and sealants. The kind of stuff you might find in your favorite hardware store. The kind of stuff Walter White might have mixed to blow apart a lock or an enemy’s face. Even the world’s most famous fictional meth cook, though, could not have cooked up something as destructive to investors as RPM’s 2.25% convertible bond due in 2020. It’s not RPM’s fault. The company tapped a richening convertible market in late 2013. Its bonds carry the weakest of so-called “investment-grade” ratings, but that’s still good enough for most funds mandated to own only bonds so approved by rating agencies. That’s right, the same rating agencies who helped bring you the financial crisis and Enron. There aren’t many investment-grade convertibles out there, so the few and proud get bid up to levels that often don’t make much sense. Frankly, RPM should take advantage of the demand for its credit and go issue a bigger, uglier convertible. Listen, there’s nothing rotten (that we know of) in the state of RPM. So far as we can tell the company is pretty rock-solid. Its annual dividend has grown without fail as far back as the eye can see. The price of its convertibles is another story. I could tell you how overvalued the bonds are according to traditional convertible models. I could show you how bad these bonds look on a proprietary measure my firm has developed–easily the most expensive bond in an expensive market. But stories usually work best, so I’ll tell you a couple. We’ll just have to go into the future a few years, to the end of 2017. Let’s say the stock has appreciated 50% from today’s level over the three and a half years. That’s about 12% annually, compounded. Nothing wrong with that for a nice, steady company, particularly after an extended bull market. RPM’s convertible bond goes for a little above 120 cents on the dollar with the shares around 45. Most investors think that when they buy convertibles trading well above par like this, they’ll get a pretty good chunk of the stock’s upside. Let’s say two-thirds. So if RPM stock appreciates 50% from now to the end of 2017, and you own the bonds (or have someone buying them on your behalf), you can be forgiven for thinking you’ll make something in the 30-35% range on the bonds over that period. Not quite 10% a year, but close. Guess again. If the stock is trading up 50% from current levels at the end of 2015, it would be at around 67 ½. This would allow the company to call the bonds away from holders, who would get around 127 ½ for their bonds—about 6% more than the current price. That’s a lot less than 30%. The disappointment might be eased a bit by the 2.25% annual coupon—but not really, because the stock’s dividend would pretty much get you that income as well. So RPM’s convertible is a horrible way to go for upside, especially of a methodical stock that doesn’t figure to blow anyone’s doors off. Makes you wonder what the point of owning it is. If you’re hanging in there, you might say that at least the bonds will protect your downside a lot better than the stock. That’s the key rationale behind convertibles. But, given how expensive they are, will they? Remember, this company has paid an increased annual dividend every year for 40 years. We’re not talking fulminated mercury here. Let’s say the market comes off and the stock drops 15% over the next three and a half years. That would put the stock right where it was when the bonds were issued. Theoretical models suggest the bonds would go for around 97 cents on the dollar. We’ll be generous and say 100. That’s basically 17% below today’s price. Remember, the stock dividend and bond coupons are essentially a wash. To recap: in these very reasonable scenarios, this bond gives you 12% of the stock’s upside and over 100% of its downside. If you’re unfamiliar with convertibles and own these bonds, you clearly don’t know what kind of underperformance you’re heading for, so let me clue you in. You are in danger. The RPM convertible is the bond that knocks. Pakistan Market Subscribe Free Foreign Market News
Courtesy:  forbes Your Keywords Here