HealthSouth problems cloud upcoming convertible pay-off; hedge funds pained by premium squeeze

By Ronda Fears

Nashville, March 19 - HealthSouth Corp. shook up the convertible market Wednesday as accounting problems turned into an alleged $1.4 billion fraud case, but there was little to do about it.

Elsewhere in convertibles, dealers said trading was very thin just hours ahead of the war in Iraq, although it was noted that many health-related converts suffered severe markdowns as a result of the HealthSouth news.

Holders of HealthSouth's convertible, the 3.25% issue, were less than two weeks away from the maturity date of April 1, but now the $350 million pay-off is in jeopardy.

A few trades were said to have been made in the converts very early Wednesday in the 30s and 40s, but the Securities and Exchange Commission suspended trading of all HealthSouth securities amid the newsflow on the charges.

The HealthSouth converts were quoted all over the map, but the levels were essentially moot given the circumstances.

"When you can't trade them, a quote means nothing," said Jimmy Giordano, president of JGiordano Securities, who ventured that it seemed very doubtful the convertible would get paid off at maturity.

Standard & Poor's and Moody's Investors Service also seemed to believe redemption of the convertible was in question.

S&P cut HealthSouth's senior ratings to B- from BB-, noting that the guilty plea of a former HealthSouth executive to fraud charges "adds a significant measure of legitimacy" to allegations that the company overstated earnings by $1.4 billion and overvalued assets by $800 million.

HealthSouth reported income before taxes of $1.6 billion from 1999 through June 30, 2002, but it really made only $169 million, according to the SEC complaint.

"HealthSouth's ability to manage its upcoming maturity of convertible notes due April 1, 2003, is also more questionable with today's charges and allegations," said S&P analyst David Peknay in the agency's rating release.

With a possible covenant violation already triggered and HealthSouth likely in need of refinancing the convert, he noted it is unclear what the response of its bank group would be.

Moody's expressed similar concerns, cutting HealthSouth senior debt to Caa1 from Ba3.

"Although the company has a $1.25 billion revolving credit facility in place, Moody's believes that the availability of this facility is in question due to representations and warranties that must be met at time of borrowing," the rating agency said.

"Further, Moody's notes that the existence of a negative pledge under this facility and the [convertible] bond indenture may be a complicating factor, limiting the ability of the company to provide security to its lenders."

The shockwave spilled over into several other healthcare names, like Sunrise Assisted Living Inc., WebMD Corp., and Province Healthcare Co., but there was not a huge sell-off in the group.

Overall, dealers said trading in convertibles was very thin just hours ahead of the expected war in Iraq.

"Convertibles are caught in the crossfire, so to speak, of the so-called flight-to-quality strategy of selling stock to buy bonds," said the head convertible trader at one of the major investment banks.

"But sitting with a portfolio of convertible can be called a flight-to-quality strategy in and of itself. There just aren't many convertible mangers stirring the pot right now."

Outside of the healthcare group, traders mentioned a rebound in Tyco International Ltd. and a sharp rise in Mirant Corp.

Mirant's 5.75% convertible due 2007 was quoted up 4.75 points on the day to 53.125 bid, 54.125 asked with the stock unchanged at $1.64.

Tyco's 2.75% convertible due 2018 added 1.375 points to 93.375 bid, 93.5 asked and the 3.125% due 2023 gained 1.75 points to 91 bid, 91.375 asked. Tyco shares closed up 52c, or 4%, to $13.17.

Another complication in the market is that hedge funds are beginning to feel some discomfort.

"Over the past several trading sessions, the stock market has rallied pretty significantly but the converts have lagged because of the high premiums," said Giordano.

"Premiums are starting to come in and the hedgers are starting to get hurt a little bit. I expect that will be corrected over time, though."

The primary market was stilled for the most part in the immediate advance of the war, too.

CAE Inc. launched a drive-by early Wednesday to price after the close, pitching $100 million of convertible floaters talked to yield the three-month Libor plus 0.25% to 0.75% with a 30% to 35% initial conversion premium.

There was little talk of it in the market, however.

Some buzz was circulating about a couple of other new deals, but nothing ever came of them. One mentioned Altria Group Inc., the old Phillip Morris Cos. Inc., and the other involved Goldman Sachs monetizing a stake with an exchangeable.

"Anything's possible," said one convertible trader at a hedge fund in New Jersey.

"But it's strangely quiet in convertibles today. Maybe it's the calm before the storm. I think once the war starts, if there's a clear sign that it will be over with shortly, like in Desert Storm, then people may begin to adjust positions."

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