Merrill Doubles Its Pleasure on Convert Deal

Investors fell all over themselves trying to get a piece of Merrill Lynch's (MER Quote - Cramer on MER - Stock Picks) new convertible bond issue.

Thursday morning the broker doubled the size of its convertible bond offering, to $2 billion; investors said the terms of the deal made it incredibly compelling. Together with recent similar offerings from blue-chip issuers like Ford(F Quote - Cramer on F - Stock Picks) and GM(GM Quote - Cramer on GM - Stock Picks), the Merrill deal shows investors are eager to get their hands on these bonds, regardless of the negative connotations sometimes associated with them. Merrill Lynch shares fell 3% Thursday morning to $52.72.

Libor Day

Rather than offering a fixed rate, Merrill's zero-coupon convertible fluctuates with short-term interest rates. The yield on the bonds will be set according to three-month Libor minus 2%, and will be reset quarterly. (Three-month Libor, the London Interbank Offered Rate, is at 1.94% currently. There is a provision that the bonds can never yield less than zero.)

This gives the notes something like a natural hedge, says Barry Nelson, research director at Advent Capital Management. Theoretically, a low-interest rate environment is good for financial services companies like Merrill. If rates stay low, Merrill's stock should trade higher, and investors will be able to convert the new notes into Merrill stock with a nice return. Higher rates might damage Merrill's stock, but then investors will be protected because the rate on the convertible will have risen, too.

Merrill is only the latest issuer to yield to rising demand in boosting its convertible offer. Earlier this year Ford sold a record-setting $5 billion bushel of converts after earlier planning to sell just $3 billion of the so-called trust preferred securities. Similarly, GM sold $3.3 billion worth after investors' clamor for the bonds drove it up from an initial plan of $2.5 billion.

Indeed, convertible issuance doubled last year as the sputtering stock market and increasingly conservative lending environment pushed capital-hungry companies into these hybrid securities. Convertible bonds entice issuers by dangling a juicy stock payout, but down the road, preventing immediate shareholder dilution.

Sputtering, Misfiring

Still, worries about dilution often hurt shares of convertible issuers, as Merrill's slide Thursday morning shows. And some investors contend that selling convertible bonds raises a caution flag because it can indicate an issuer has run out of other, more attractive funding options. There's no indication of any such problems at Merrill, however, observers say.

And with stock investors jittery and the market for short-term, low-cost commercial paper growing ever more choosy, the fact is that more and more companies are looking for other capital-raising alternatives.

In Merrill's case, despite a substantial premium on the notes, Nelson says Advent was a buyer. "This was irresistible," he says. "We're in."