Junk Bonds Take a Back Seat to Convertibles: Rates of Return
By Lee Theodoros

Junk Bonds Take a Back Seat to Convertibles: Rates of Return

New York, March 21 (Bloomberg) -- When John Brittain,
treasurer at Nextel Communications Inc., was considering how to
finance the company's expansion in January, he was faced with the
option of selling stock or debt. He chose both.

With the Reston, Virginia-based wireless phone company's
shares up four-fold in the past year, and the high-yield bond
market in the doldrums, Brittain opted to sell convertible bonds
for a second time since June.

At just a day's notice, Nextel issued $1 billion of
convertible notes with a 5 1/4 percent interest rate -- more than
four percentage points lower than the yield it paid on its most
recent junk bond sale in November.
``It made absolute sense,'' said Brittain.

Nextel isn't the only borrower branching into the $200
billion convertible debt market. Primus Telecommunications Group
Inc., Level 3 Communications Inc. and Pinnacle Holdings Inc. also
sold them, putting sales on track for an all-time high this year.

About 62 borrowers -- predominantly risky or unrated
businesses -- raised $21.7 billion in the convertible market year-
to-date, a record for that period, according to Lehman Brothers
research. Based on the pace of sales so far, the years' total
could reach $50 billion, overtaking last year's record $44.2
billion of offerings, analysts said.

Junk bonds are being ``bypassed by some companies'' in favor
of the convertible market, especially by fast-growing telecom and
Internet companies, said Bob Kricheff, a managing director and
high-yield bond analyst at Credit Suisse First Boston. Companies
have already raised some 40 percent more money in the convertible
debt market this year than they did selling junk bonds.

`More Forgiving'

Part of the appeal in selling convertibles lies in the lower
interest rates a company achieves, in exchange for giving up some
of its shares. At the same time, the potential for big gains in an
issuer's shares makes investors ``more forgiving,'' allowing
companies that might otherwise be shut out of the high-yield
market to raise funds, said Ravi Suria, head of the convertibles
research group at Lehman Brothers.

If a company's shares keep rising, the bonds -- which
increasingly are being bought by high-yield mutual fund managers
-- do well. If the shares fall, losses are cushioned by semi-
annual interest payments and the promise that the securities will
be repaid at face value at maturity.

The rosy outlook for convertibles stands in sharp contrast to
the junk bond market, which is wallowing for a third straight year
even as the Nasdaq Composite Index -- home to many of the telecom,
Internet and high-tech companies that are selling convertible
notes -- has reached a record. The stock index is up more than 14
percent so far this year.

Junk bond prices fell 8 percent in the 12 months ended in
February, and returns to investors were just 0.97 percent
including interest, according to a Merrill Lynch & Co. index. That
compares with returns of about 44.1 percent on convertible notes
sold in the period, according to Warburg Dillon Read

The stock market's stunning gains have lured investors from
junk bonds -- prompting withdrawals of almost $3 billion from high-
yield mutual funds the past 15 weeks. Rising interest rates and
defaults near their highest level since 1991 also have made it
more costly for many borrowers to raise funds, and discouraged
buyers from taking a chance on riskier companies.

On The Shelf

``The good performance is in the equity market, not in high
yield right now,'' said Kevin Mathews, who helps manage $3 billion
of junk bonds at Pilgrim America Group in Phoenix.

Adding to interest-rate concerns, the Federal Reserve today
raised its target for overnight bank lending in the fifth quarter-
point move since June. The rate is now 6 percent, the highest
level in almost five years.

Among borrowers dissuaded from selling debt by the current
environment, Mandalay Resort Group, the fourth-largest U.S. casino
company, shelved a bond sale this month rather than pay fat
yields. Others, including Colo.com and XM Satellite Radio Holdings
Inc., included equity warrants with already hefty yields to drum
up demand.

The convertible market is another story.

McLean, Virginia-based Primus, which provides voice, data and
Internet services entered the convertible market for the first
time in February, raising $300 million with notes that readily
found buyers.

Primus, whose stock is up almost four-fold the past year,
sold seven-year convertible notes with a 5 3/4 percent yield --
about half the yield on its outstanding high-yield notes.

`Best Deal'

``We looked at all the different options -- and with our
stock price rising, a convertible note sale seemed to be the best
deal,'' said Neil Hazard, executive vice president and chief
financial officer. And the high-yield market, where four-year old
Primus had borrowed before, ``wasn't doing so well,'' he said.

Other recent borrowers include Broomfield, Colorado-based
Level 3, which is building an optical fiber phone and data network
in the U.S. and Europe, and Sarasota, Florida-based Pinnacle,
which owns and manages wireless communications towers.

To be sure, the appeal of convertible debt is contingent on
further gains in the stock market, which aren't assured. The
Nasdaq index, while up for the year, has slipped almost 9 percent
from its record 5133 reached earlier this month. And there are
only so many shares a company is willing to offer.

For now though, lower-rated companies such as Redback
Networks Inc. aren't letting the chance go by to raise money at a
lower cost than they'd face selling junk bonds. The company -- a
maker of equipment to ease data traffic on high-speed online
services, whose shares have surged 87 percent this year -- is
readying a $500 million sale.
``The cost advantage for a lot of companies is a no-
brainer,'' said Sri Nadesan, director of convertible securities at
Warburg Dillon Read. ``It's very hard for a chief financial
officer to ignore.''