Citigroup European convertible analyst sees 25% chance of widening credit spreads, falling volatility

By Ronda Fears

Nashville, Jan. 13 - Citigroup Global Markets Inc. convertible analyst for Europe Christopher Davenport said in a report Tuesday that he sees a relatively high likelihood that European convertibles could suffer a double whammy in 2004 from widening credit spreads and falling volatility. Davenport, however, is making no changes to his recommended list of holdings due to the resilience of the asset class.

For 2004, the talk is largely of a continuation of the trends seen in the last three quarters of 2003, Davenport said. He generally agrees, attaching the most probability to the scenario in which spreads continue narrowing while volatility also continues to decline.

"Strategists look to solid growth, stronger balance sheets and fewer surprises, so it is hard to argue with the view that markets could become calmer yet. Nevertheless the dramatic reversal of fortunes last spring acts as a reminder as to how quickly things can change."

In early 2003, he said, when equity markets were experiencing dramatic declines, many participants in the European convertibles market considered a simultaneous rise in spreads and volatilities a plausible scenario for 2004.

Yet, the opposite occurred, with compression in both credit spreads and implied volatilities.

Thus, Davenport said, "Even the implicit assumption that credit spreads and volatilities will continue to move in the same direction is open to challenge."

The analyst assigned a 40% probability to spreads narrowing and volatilities declining and, conversely, a 10% probability that spreads narrow while volatilities rise. But, he also said it is 25% possible that spreads widen and volatilities rise, and equally 25% possible that spreads widen and volatilities decline.

"The worrying part of this is the relatively high probability we assign to the 'worst case scenario' of convertibles being hit with the dual negatives of falling implied volatilities and rising credit spreads," Davenport said.

"The point is that [as] most of the fall in convertible implied volatilities came between March and August; they were remarkably resilient in the last three months of the year against the backdrop of further erosion of realized volatility, and now look vulnerable.

"Credit spreads, on the other hand, have fallen to such an extent that in many cases there seems little room for further ease."

European convertible issuance climbed in 2003, he noted, to €40 billion from €23 billion in 2002. The average issue size of the 68 deals was €582 million. In U.S. dollars, the total for 2003 actually set a new record at $45.3 billion, just beating 2001's $45.2 billion.

At present, Davenport said there were no changes being proposed to the Citigroup recommended European convertibles portfolio, which consists of the BskyB/News Corp. 0.75% due 2023, Hilton 3.375% due 2010, Pernod Ricard 2.5% due 2008, BAA 2.625% due 2009, Adecco 0% due 2013, Xstrata/Glencore 4.125% due 2010, Continental 2% due 2004 and Logica 2.875% due 2008.

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