I have tried unsuccessfully to explain the reasoning behind my belief that holders of Sirius XM Radio's 7% convertible notes will likely convert, and alleviate Sirius XM (NASDAQ:SIRI) of 550 million of long term debt in the not-too-distant-future. It is one of many reasons I had given to support my belief that Sirius XM shares will appreciate in value in 2011. Let's try it again.
Let's start with a few bond basics as a primer. Let's assume that a company issues a bond that pays 5% interest and that the bond has a face value of $1000.00. The buyer of that bond would receive $50.00 per year, and would receive the full face value back at maturity. As investors build bond portfolios over time, the interest income can be substantial. Government bonds carry tax advantages, while corporate bond income is fully taxed. For this reason, corporate bonds pay higher interest to compete with government bonds. Bonds can be bought for income, but they can also be traded like stocks.
If interest rates rise, new bond issues will pay higher interest which in turn devalues the bond used in the example above. If interest rates fall however, the bond rises in value because it pays higher interest. This is where the concept of yield to maturity comes in. If you bought that same bond for $1200.00, you will still receive the $50.00 interest each year, but at maturity you will only receive the $1000.00 face value. The interest or "coupon" therefore is not nearly as important as a bond's yield.
Interest rates have fallen to historic lows, and the expectation is that they will begin to rise soon. That means the value of bonds is likely to fall. Here is a Sirius XM bond with a 9.625% coupon. The high interest payments relative to the current credit market environment have caused the price of bond to increase, and as a result the yield on this bond purchase was just 3.859%. As a result of the higher premium, the last time this particular bond traded, was back in April of 2010.
(Click to enlarge)
Part 2: Convertibles and Arbitrage
Convertibles are seldom bought for interest they generate but rather bought by investors who are bullish on a company's stock. Convertible buyers receive the interest, while waiting for a stock to rise. If the conversion price is not met by a certain date, the convertible buyer receives the full face value at maturity. The risk of loss is therefore minimized. Similar to bonds, as interest rates fall, the price of the convertible rises. This is always dictated by credit market rates. If new convertibles are paying lower rates, existing high rate convertibles command a premium, and therefore have a lower yield to maturity.
In the case of the Sirius XM convertible note that is the subject of this lengthy explanation, it was offered through a private placement to Qualified Institutional Buyers (QIBs). It does not trade on the open bond market, making it illiquid for the most part, although it does trade privately through the PORTAL market. The buyers of these notes did not do so for the 7% interest payment, but rather for convertible arbitrage purposes.
Note the yellow arrow in the photo above. That is where Sirius XM currently stands on this convertible arbitrage chart. The green box is where the convertible fund managers are able to exploit the premium between the convertible price and the conversion value. Notice that at no time does the convertible price fall below the bond value. Also notice, that the yellow arrow is well above the bond's value, in red. The arbitrage opportunity has for the most part, passed and was highly successful.
We can actually track the convertible note to some extent through the filings provided by Sirius XM on behalf of selling shareholders. The buyers of the notes assigned a few select funds to manage these investments for them. Arbitrage specialists such as Canyon Capital and Penn Capital no longer hold these convertibles for themselves nor their clients, according to 13F filings available through the SEC database.
One of the largest managers is ADVENT Capital Management, which happens to specialize in arbitrage opportunities. Not only does ADVENT hold a large position in these Sirius XM notes which has been increasing over the past several quarters, it manages the notes of about thirty other large institutional owners. The picture above came directly from the company's website, which suggests the fund management company will no longer be interested in holding the Sirius XM notes, as the returns will be much lower than the company's established goals.
What they are left with, are essentially illiquid notes, priced well above par and probably at their peak, within reach of the conversion price. This is true of most, if not all of these note holders. Not only is more likely than not that these notes will be converted, it is possible that some conversion has already taken place, as the institutional holders vie for positioning with an exit strategy. This would not be outside the scope of possibility, given the thousand percent gains were potentially made on the arbitrage. To reason that these noteholders would wait or be content with a 7% coupon, is infantile.
Disclosure: Author long SIRI