Shares of American Realty Capital Properties (ARCP) have fallen over 6% since last Friday’s close after the Chairman, CEO and President resigned from the company. If you are wondering why the CFO is not on the list – he was already fired after first admitting to accounting irregularities. There was no official reason given for the executive departures, but no doubt they are tied to the investigation. In fact, the investigation looks like so much fun, the FBI and the SEC are looking into the situation with the FBI considering filing criminal charges.
When the ARCP accounting story first broke, we penned an article, “A House Divided”. In our piece, we argued that the convertible may be the better way to play any rebound over common shares given the ongoing headline risk. Now a Hybrid Vigor friend and reader on a major New York trading desk has come up with a pretty slick way to hedge the convertible trade given that things have gotten even uglier.
His idea is to short the 6.70% $25 par preferred shares against the 3.75% 12/15/2020 senior unsecured convertible note. He reckons that if things get worse, the spread between the two securities should blow out as the convertible is senior to the preferred stock in the debt stack. A home run would be bankruptcy as the company has hard assets to back the converts in recovery whereas the preferred equity would be largely wiped out. Right now the spread between the convertible note and the preferred stock in bond terms is less than one point with the ask on the bond at 86.5 and the preferred trading at $21.50, or 86% of par.
Here are scenarios with a convert to preferred hedge ratio of 1 to 0.75:
If the storm passes for ARCP, which seems unlikely at this point, the converts should appreciate at least as quickly as the preferred equity, which is callable at par beginning in October, 2018. With the convertible, investors get a six year maturity and a call option on the stock while the preferred equity offers only a coupon in perpetuity. On the downside, which seems like a possibility, the bond features of the convertible note trump the preferred equity. If ARCP gets taken out, the convertible security also has a change of control put at par.
In fact, it seems like the market does not have a good handle on where the convertible security lies in ARCP’s capital structure. We suspect the reason is higher retail demand for the preferred stock versus demand for the more institutionally traded bonds.
Our reader notes that the ARCP’s 3% February 2019 straight debt is trading at a stiff 6 point premium to the 2020 converts. It is true that the bonds have a shorter maturity and are structurally superior to the converts because the straight debt has subsidiary guarantees while the convertible bonds are holding company debt. However, the convertible security has the call option embedded in the convertible which maintains value despite the drop in the stock price. That six points to pay up for the straight debt seems even more out of whack when the market is only demanding less than a point to make a greater leap in the debt stack from preferred equity to the convertible.
Another point to consider; while the cost of carry is about 3%, the bond’s accretion can help cover the cost.
It is pretty obvious our friend has done his homework here.
The thing we like about the trade, other than the potential monetary rewards, is it highlights how smart our readers are………