Shareholders getting nervous about the pace of Finisar's ( FNSR) recent run-up, but who still sense upside in the shares, should consider a hedge fund tactic: buying the convertible bond. Finisar, which has been riding a rally in the fiber-optic space, is already up 135% this year to about $4.86, trading a crushing average of 12 million shares a day. "Finisar is a company that many consider the gold standard for fiber-optics testing equipment," says Eric Hage, chief investment officer at convertible arbitrage hedge fund Mohican Financial Management in Cooperstown, N.Y. The shares are benefiting from a reversal of fortune. After losing money for years, it is expected to earn about $9 million this year and $52 million next year, according to Thomson First Call. "Finisar has a history of terrible earnings," says a hedge fund manager. "It's always good when earnings move from negative to neutral or positive." Bulls have enjoyed a nice ride, but at current levels (30 times this year's Thomson First Call consensus), the air is getting thin. "We just sold our position," says one hedge fund manager, who had been among the top 20 holders. Insiders have sold more than 5 million shares over the past six months. Clearly, caution is appropriate -- and that's where the convertible bonds come in. "If you know the stock price is going to go higher, you're better off buying the stock," says Hage. "But if you're bullish but not sure, buying the convertible
bond is a more attractive risk/reward play." Here's how it works: Finisar's convertible bond pays a 2.5% coupon and can be converted into 270 common shares. Currently, the bond trades in the secondary market for $1,440, about 10% more than those 270 shares are worth on the Nasdaq. The premium reflects factors including the volatility in the stock, which has basically quadrupled in a year.
The bond's price also reflects its downside protection. One attractive feature of this security is that it can be sold at the owner's discretion back to the company for $1,000 in October 2007. In other words, once the common shares trade below roughly $3.70 apiece -- where 270 shares are worth about $1,000 -- further declines won't have a major impact on the bond price. Let's look at an example. Right now, the bond is trading in the secondary market at $1,440, and the stock, as mentioned, goes for about $4.86. If between now and October 2007 the stock loses 50% of its value, decreasing to $2.43, what happens? The stock's owner loses 50%. Meanwhile, the bondholder can put back the bond at par. In that case, he loses 30.5%. When factoring in the 3.75% interest earned during the 18-month period, the loss narrows to 27%. Now let's imagine that the stock goes up 50%, to $7.29, in October 2007. In this case, convertible owners can redeem their bond for shares or sell the bonds on the open market. Converting the bond would produce a superior value of roughly $1,968 (270 times $7.29.) Bondholders make a 36.7% profit plus 3.75% interest, which is 40.45%. The stockholders pocket 50% during that time. Conclusion: When the stock is up 50%, shareholders make 50%, while bondholders make about 40% -- a little bit less, but not much. And when the stock is down 50%, stockholders lose 50%, while bondholders lose 27%. By slightly limiting profits, bondholders can cut their losses by almost half. "If you want to chase the name, a better way to buy the stock is to buy the convertible because the bond gives you downside protection. The stock doesn't," says Hage. Hedge funds are playing this game, in a slightly different way. They buy the bond and hedge their position by shorting the stock. This type of trade works well when the stock is as volatile as Finisar's. If the stock goes down, arbitragers adjust their hedge by buying some stock back. If the stock goes up, they sell a little bit more of the stock. The more often hedge funds are able to "roundtrip" the stock, the more money they make on their pure convertible arbitrage play. Meanwhile, the bond appreciates in value when the stock goes up. And the bond is protected on the downside by the put provision. Is there a risk for short-sellers to be hurt by a sudden increase in the stock price? The worst-case scenario came up last spring, when convertible arbitrageurs who had bought General Motors ( GM) convertible debt and shorted its stock took huge losses. At the time, GM debt prices were deteriorating, but all of a sudden stock prices spiked because Kirk Kerkorian bought a large chunk of shares. His transaction made borrowing the stock much more costly for arbitrageurs. The convertible price should have moved up with the stock, but it did not because the bonds became unattractive due to the high cost of shorting. A repeat is unlikely in the case of Finisar, says Hage, because borrowing the stock has not been a problem: Insiders are selling.