Lehman sees 2004 convertible returns of 8-9%, modest issuance in the $70-80 billion area

By Ronda Fears

Nashville, Jan. 8 - Convertible returns should come in at about 8% to 9% in 2004, said Lehman Brothers head of U.S. convertible research Venu Krishna in a report Thursday. He expects issuance in the $70 to $80 billion area but added that returns could get a 1.5% to 3% boost from a strong calendar.

Given the expectation of modest equity market returns versus 2003, a relatively low interest rate environment, strong technicals, credit stability and a modest pickup in equity volatility in the second half of 2004, he recommends a balanced portfolio.

New issues could boost returns

Not captured in the returns expectations is the impact of new issues in 2004, which Krishna put in the $70 to $80 billion range.

"Our relatively robust expectation for new issuance in 2004 is driven by continued economic growth, improving equity markets, ongoing credit stability/improvement, and a continuation of a relatively low interest rate environment (especially given Lehman's expectation of the Fed being on hold in 2004)," Krishna said.

Yet, the expected new issue level reflects a 10% to 20% decline versus Lehman's tally for 2003 of $88.4 billion.

The decline, he said, gives consideration that the straight debt and equity markets may soak up some demand as issuers have easier access to a broader array of financing alternatives.

"On the other hand, should a pickup in interest rates and volatility materialize, it will aid convertible issuance in 2004 and cause our expectation to be conservative," Krishna said.

"Depending on new issue pricing trends, there is upside potential of 1.5% to 3% to our returns estimate driven by new issues.

"On the other hand, if the current supply/demand imbalance in the market continues and results in aggressive pricing (as seen in the first half of 2003), the prospect for any material upside from new issues could be highly limited or nonexistent."

Equity exposure suggested

After three years of declining returns, the U.S. convertible market bounced back in 2003 with a positive return of 27.88% tallied by Lehman - the second best performance for the market over the last decade.

The massive credit rally that started in late 2002, declining interest rates and the rebound in the equity markets starting in the second half of 2003 were the underlying drivers for returns in 2003.

On the other hand, Krishna noted that 2003 valuations and returns were tempered by declining volatility, increased call risk and rising common dividends.

"While at a macro level the convertible market remains fully valued and busted (with a weighted average premium of 110%), it masks a fairly diverse universe that sets up the potential for the construction of a balanced portfolio," Krishna said.

"Accordingly, we constructed our 2004 recommended convertible portfolio with the overall goal of seeking balance while capitalizing on the value drivers we foresee."

Premises that drove the choices included anticipations of strong stock prices, further spread contraction in lower quality credits, rising volatility and healthy economic growth.

A core viewpoint is that equity valuations will be the primary source of value in 2004, so the suggested portfolio has a reasonably high degree of equity exposure - a delta of 62% versus 55% for the overall market.

While spread contraction will be a much smaller source of value in 2004 compared to 2003, Krishna believes incremental value can be extracted in the non-investment-grade sector.

Volatility is expected to modestly gain, too, most likely in the second half of 2004, and is seen as an incremental source of value.

Recommended portfolio list

In all, Lehman says its recommended portfolio contains 63 securities with portfolio terms of 3.5% yield and 34% premium versus the market's terms of 4.3% yield and 110% premium.

Recommended are: AirTrans 7% due 2023, Arch Coal 5% perpetual preferred, Amgen 0% due 2032, Alamosa 7.5% preferred due 2013, Apogent floater due 2033, Computer Associates 5% due 2007, Actuant 2% due 2023, Danaher 0% due 2021, American Express 1.85% due 2033, Brinker 0% due 2021 and Best Buy 2.25% due 2022.

Also recommended are: General Mills 0% due 2022, Carnival 1.125% due 2033, Gap 5.75% due 2009, Chesapeake Energy 5% perpetual preferred, Hasbro 2.75% due 2021, Capital One 6.25% mandatory due 2005, Hutchinson 2.25% due 2010, Cymer 3.5% due 2009, Interpublic 5.375% mandatory due 2006, Doral 4.75% perpetual preferred, L-3 4% due 2011 and Kodak 3.375% due 2033.

Also recommended are: Lowe's 0.86% due 2021, Emulex 0.25% due 2023, 3M 0% due 2032, Exult 2.5% due 2010, State Street 6.75% mandatory due 2006, Freeport McMoran Copper & Gold 7% due 2011, TJX 0% due 2021, Fairmont 3.75% due 2023, Tyco 2.75% due 2018, Fair Isaac 1.5% due 2023, Washington Mutual 5.375% preferred due 2041, Fleetwood 5% due 2023 and Watson 1.75% due 2023.

Also recommended are: Flextronics 1% due 2010, Genesco 4.125% due 2023, Charming Shoppes 4.75% due 2012, Guitar 4% due 2013, Northwest Airlines 7.625% due 2023, Halliburton 3.125% due 2023, Six Flags 7.25% preferred due 2009, Ikon 5% due 2007, Sonic Automotive 5.25% due 2009, Jabil 1.75% due 2021, Kroll 1.75% due 2014, Medtronic 1.25% due 2021 and Maxtor 6.8% due 2010.

Also recommended are: Northrop 7% preferred due 2021, Omnicom 0% due 2033, OSI 3.25% due 2023, PMI 5.875% mandatory due 2006, Sealed Air 3% due 2033, Sepracor 0% due 2008, Schlumburger 1.5% due 2023, Serena 1.5% due 2023, Supervalu 0% due 2031, Skyworks 4.75% due 2007, Travelers 4.5% preferred due 2032, Veritas 0.25% due 2013, Williams 9% mandatory due 2005 and Wyeth floater due 2024.

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