With garden-variety convertible bonds, the credit spread used in modeling has some impact on discounting the bond’s annual coupon payments, but not nearly as much as on the value of the promised principal repayment. With mandatories, though, the principal payment is either completely certain or completely uncertain, depending on how you look at it. The certainty is getting shares (or their equivalent), and the uncertainty is their value. Either way, applying a credit-based discount rate is the wrong approach.
The credit spread still does matter, though, for discounting the mandatory’s dividend payments, and this is sometimes not trivial. Consider today’s new issue, Dynegy. Often stained in investors’ minds by its connection with Enron, Dynegy is a fairly speculative credit compared with recent mandatory issuers Tyson and Alcoa. As such, you need to discount the cash flows instead of turning a slightly blind eye to the time value of money, which you can sort of get away with on certain other mandatories.
The difference between a “yeah, don’t worry about it” credit assumption for the three years of cash flows and a “let’s pay attention” assumption probably comes out to as much as 1%, or a bit more, of the value. It’s so difficult to make a major error valuing a mandy—because of the relative unimportance of both credit and volatility—that it’s kind of interesting to see one with some play in the numbers. Going from a three-point volatility spread to a five-pointer is worth another percent or so. Again, there’s more play than usual in the inputs.
We’d probably be on the cautious side here. We think, if you’re being cautious, the pricing was a bit of a stretch. Then again, the beauty of mandys is usually their optics, and the Dynegy preferred is no exception. To like it, all else equal, we’d have needed a six-handle in the dividend.