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This episode aired on Bloomberg TV on Aug 18, 2013

Happy Meal

Q. So, its somewhat surprising to hear that JDS Uniphase, the optical products company, is offering a Happy Meal today. I think we need an explanation.

A. Well, in convertible bond land, a “happy meal” is a convertible bond issuance that is coupled with a stock buy back… that’s what JDSU is doing. Right off the bat, note that this makes the buyback EPS accretive (fewer shares in the market). But the people it really makes happy are the convertible arbitrage guys.

Q. So… to review, we know that the basic covertible arbitrage trade is to buy a convertible issue, and go short the stock, right?

A. Right. In the bond, they’re getting the right to convert the bond into stock at a predetermined price… that’s the core idea of the instrument. So going short the stock at the same time means they’re neutral on the stock itself.

Q. OK, but where’s the “happy meal”?

A. The arbs get offered a package: the convertible bond along with the short position in the stock, where the short is set at exactly the same price as the convertible option in the bond. No muss, no fuss, all together in one deal But no toy.

Q. So that makes them absolutely neutral on the stock itself.

A. Right, and that makes them happy. What’s left is the bond component, of course, but also the value of option right. And that’s the piece that the market typically undervalues. With a happy meal, its relatively easy for the arbitrageurs to capture that inefficiency.

Q. And the company likes all this because it makes the issue easier to sell?

A. Sure. Of course, they also like it for the basic reason that the convertible feature allows them to sell it at below market interest rate, and that any equity that does get issued will be above the current market price. But doing it along with a buyback should make it easier for the arbs to buy it and improve the market appetite.