Merrill convertible analyst suggests adjusting duration for interest rate risk immunization

By Ronda Fears

Nashville, Jan. 23 - Merrill Lynch & Co. analyst Marc Malloy on Friday said the U.S. convertible market's overall relatively high conversion premium of 49.8% and low investment value premium of 33% makes interest rate sensitivity important and suggested adjusting duration of portfolios for insulation.

Historically, interest rate sensitivity has not been a focus of convertible outright managers due to the high equity sensitivity of the convertible universe, Malloy said in a report Friday.

But as convertibles trade closer to their fixed-income values, they become more vulnerable to movements in interest rates.

To lower duration by restructuring, a portfolio manager might replace longer-term notes with shorter-term notes, buy higher coupon bonds or increase the percentage of cash held.

For mangers not wanting to change the structure of their portfolio due to transaction costs, tax consequences or otherwise, Treasury bonds and futures can hedge interest rate risk exposure.

Also, the analyst pointed out that fixed-income managers can lower their interest rate exposure by including convertible securities in their portfolios.

Higher rates anticipated

"Whether or not the Fed's sustained reflationary efforts pay off in 2004, investors will likely continue to anticipate that super stimulative monetary policies will eventually push core consumer inflation higher," and that will likely result in the potential for rising interest rates, Malloy said.

Merrill's fixed-income strategy team is calling for a 6% 10-year Treasury by year-end.

Thus, with the convertible universe now having an average conversion premium of 49.8%, parity delta of 0.55 and investment value premium of 33%, interest rate sensitivity becomes important. Malloy noted that while the convertible market's average conversion premium has contracted sharply over the past year, it is still well above historical norms.

Duration is a measure of the equity sensitivity of a bond to interest rates. With the majority of U.S. convertibles clocking an effective duration of less than two years and the weighted average of the entire U.S. convertible universe standing at 1.77 years, prima facie, the risk to convertibles as a whole to changing interest rates would appear to be low.

As an illustration, the analyst said the Merrill U.S. convertible index would lose roughly 3.1% if yields increased by 200 basis points, assuming a parallel shift of the yield curve.

"Given our 2004 outlook of single digit returns for the convertible market, a manager looking to add alpha should consider hedging out interest rates," Malloy said.

Assessing convertibles

To hedge interest rate risk with duration management, considerations include the affect of embedded bond and equity call options on a convertible's duration as well as using Treasuries and futures.

As expected, Malloy said convertibles that are more equity sensitive have lower effective durations, which is evident when comparing the indices in terms of delta.

He noted, too, that speculative-grade convertibles, both including and excluding mandatories, are less interest rate sensitive than their high-grade counterparts. Also, when comparing effective duration by company size, small caps have a greater weighted average effective duration than mid and large caps.

Also, noteworthy is the fact that effective duration of convertibles in Merrill's new issue index, which tracks them for six months, is slightly larger than that the overall market, which Malloy attributed to the decline in equity values since many of these convertibles were issued.

High-, low-duration choices

Convertibles with some of the highest effective durations listed in the report include both Comcast/PCS 2% exchangeables, the Liberty Media/PCS 4% exchangeables, the Lucent 8% convertible, the Newell Rubbermaid 5.25% convertible preferred, the Hewlett-Packard 0%, the Owens-Illinois 4.75% convertible, the Tower Auto Trust 6.75% convertible preferred and the AES Trust III 6.75% convertible preferred.

Convertibles with some of the lowest effective durations listed in the report include the Spacehab 8% convertible, Nabors Industries 0% convertible, Wyeth's floater, the JMH Financial/JPMorgan 4.75% exchangeable convertible, the Valeant Pharma 4% convertible, the Bristol-Meyers floater, the TXU 2.65% convertible and the Delta Air Lines 8% convertible.

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