CHK And CHK Converts

Chesapeake Energy (CHK) convertibles offer investors a way to participate if the stock goes up or get a nice yield if the market goes back down.

The convertibles are currently paying a 6% yield to investors. Bonds mature at $1,000, and Chesapeake's are trading at $475. Each bond converts into 11.6428 shares when the stock reaches $85.9 a share. If you do the math, it equals $1,000 a bond.

The bonds are rated BB. Technically, they are junk rated. In a bankruptcy, banks and bond holders have first claim on assets. After that, claims go to accounts payable, preferred-stock holders and, at the end of the line, common-stock holders. Should the company go out of business, convertible-bond holders would get a claim on the value of Chesapeake's land, rigs and drilling rights. These assets would be sold, and the cash left over would be given to each class of creditor standing in line.

But Chesapeake isn't going out of business. It's a well-run company in a very volatile industry: natural gas. As of Dec. 31, 2007, it had 10.9 trillion cubic feet of natural gas in proved reserves. It had $4.6 billion in sales in 2005 and $7.8 billion in 2007. That's what you call a growth company!

Natural gas is about $6.50 per million British thermal units. Back in June, it was trading at over $13.

T. Boone Pickens and his buddies are trying to get the government to convert buses, trucks and autos to using natural gas. The U.S. has an abundance of natural gas and a dearth of oil. If this conversion happens, you know that natural gas prices will skyrocket.

Chesapeake's CEO and founder is the famous Aubrey McClendon. He recently bought the Supersonics basketball team and is moving it to Oklahoma. Unfortunately, he had to sell most of his stake in Chesapeake because of margin calls. Lesson to be learned: Don't use margin!

Earnings were released Thursday. The company earned 85 cents a share, which is a 47% increase from a year earlier. The company profited from high energy prices and hedges that were in place.

The convertible does trade at a high premium to the common stock. The conversion premium is 89%, meaning that the common stock will have to increase from $21.62 to $40.80 for the bond to be equal to what the stock is trading. Part of the reason for the high premium is that Chesapeake's stock is quite volatile. Its 52-week high is $74, and its 52 week low is $12. The more volatile the stock, the higher the option premium. The odds are higher that volatile stocks can go up in a lesser amount of time than low-volatility stocks. Chesapeake's stock has increased 70-fold from February 1999 to June 2008.

If the stock market tanks, energy producers will prove to be defensive in nature. Oil is a fungible product, meaning that people all over the world pay the same price for a barrel of oil. People in Saudi Arabia, Ireland, New Zealand and the U.S. all pay $65 in U.S. dollars for one barrel. Natural gas prices have a high correlation with oil prices.

As Indian and China whet their thirst for energy, prices will rise in tandem all across the globe. The recent drop is due to widespread selloffs of all asset classes and global recession fears. Eventually, emerging markets will get back on track and use more energy.

If you decide to buy this convertible, be aware that it can't be bought like an equity. You must go through your broker's bond desk. The CUSIP number is 165167CB1.

Over the last many years, it didn't make sense to buy convertible bonds. The yields were often times less than 1%. Many hedge funds would buy convertibles and short the equity, pocketing the bond's coupon. As hedge funds imploded, they had to unravel these trades. For the first time in years, individual investors can partake in this security with a nice yield, downside protection and upside potential.

Long: CHK common