"Convertopia" not probable, but 2004 still looks positive for euro converts: Barclays

By Ronda Fears

Nashville, Jan. 30 - Convertible investors in 2004 face a dizzying array of potential influences - some of them positive, others negative - as well as several uncertainties, but Barclays Capital Markets analysts believe that, overall, the combination of these factors will be neutral to mildly positive for valuations in the European convertible market.

In a report Friday, Barclays analysts Luke Olsen and Haidje Rustau also take a glimpse of "Convertopia: A world where our predictions do not apply and, instead, everything that can possibly happen to boost convertible valuations, does."

Positive forces include rising equity markets, tightening sub-investment grade and triple-B spreads and strong demand.

Negative forces include higher sterling and dollar interest rates, underperformance of triple-A and double-A credits and increased dividends.

Uncertainties include merger and acquisition activity, and issuance that could include some large divestment and privatization exchangeables.

"The year 2003 was a strong one for convertibles, with a plentiful and diverse supply of new issuance, strong investor demand and some positive market trends that boosted performance - notably the resurgence in credit and equity as the corporate and (to some extent) economic picture brightened," the analysts said.

"Looking ahead for 2004, we believe that the set of market forces impacting European convertible bond valuations are fairly balanced."

The analysts added, however, "Given that many market participants' funding is benchmarked to Libor, convertible bond valuations may be further impaired if swap spreads widen, as our strategists expect."

On whole, the Barclays analysts' forecast suggests that convertible valuations will benefit from moderately rising equity prices and volatilities but will be constrained by higher swap rates and, potentially, dividend increases.

In terms of credit, the analysts said high-yield/crossover, triple-B and possibly single-A credits are likely to outperform.

Hence, for valuations, the analysts favor more equity-sensitive convertibles from the sub-investment grade, telecom, or subordinated financial sectors, or convertibles from other sectors with shorter expected life in order to minimize the impact of rising risk-free rates.

They also suggest looking for dividend protection, and urge investors to consider hedging their portfolio swap rate exposure.

"Convertopia" fairy-tale

Lastly, the analysts considered "the hypothetical (and improbable) events that could create a 'sweet spot,' or best-case scenario for convertible valuations."

For that to happen, they said stocks would continue to rally, repeating last year's gains, primarily in response to improving corporate profitability, lower leverage and increased M&A activity.

Equity volatility would reverse its recent decline, despite the rise in equity levels, and would be driven higher by extraneous volatility such as the currency and commodity markets, and M&A activity.

Credit would have to continue to rally, particularly amongst triple-B, crossover and high-yield names, as the equity rally persists and as corporate issuance fails to meet demand and redemptions. The rating action/watch upgrade-to-downgrade ratio would continue to improve. Notwithstanding the increase in equity volatility, triple-B spreads tighten in line with equities, or by about 10 basis points, in addition to the current 15 basis points dislocation.

Dividend payouts would remain stable, as companies focus on using cash to service and repay debt, resulting in a 20% fall in dividend yields.

Interest rates would be kept low by policymakers in response to price pressures, such as from overseas suppliers like China, and the jobless recovery would continue. This would lead to a 50 basis points fall in five-year government bond yields and swap spreads would be stable.

Issuance would fail to match the heavy pace of redemptions, buybacks and refinancings, as some potential issuers wait for better conditions for issuance. Divestments of equity stakes would be executed via direct sales rather than exchangeable offerings. Thus, demand continues to rise as more hedge fund and institutional investors see convertibles as a high-performing asset class during 2004. This supply/demand imbalance could add 2 points of theoretical value to the convertible market.

"Under these assumptions, our valuation model would predict a total return of 18.6% for our generic convertible bond: Convertopia indeed!" the analysts said.

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