Citigroup analysts: Issuance signs still bullish; 1Q could bring 5% correction, volatility spike

By Ronda Fears

Nashville, Feb. 6 - Citigroup convertible analysts said that the U.S. convertible market posted very respectable gains in January despite retreating late in the month - seen as the harbinger of a market correction possibility as sharp as 5% in first quarter, with a resultant spike in volatility.

On the new deal front, flow was somewhat of a disappointment, but the analysts said the primary market still feels bullish.

"The January issuance totals were below expectations. Coming on the heels of a robust December calendar, the level of activity in January could only be classified as disappointing," said Citigroup convertible analyst Stuart Novick in a report.

"That said, anecdotal evidence regarding potential convertible issuance remains mostly bullish. We continue to hear that there are several deals in the works including some large-sized issues-to-be. Also, convertible funds - both outright and hedge - are rumored to be awash in cash that needs to be put to work."

Citigroup tallied 12 convertible deals in January totaling $3.6 billion in proceeds - the lowest monthly figure since March 2003.

"With momentum building within the equity market and the dearth in convertible new issues, many convertible market participants began chasing issues trying to capture a little bit of lightning in a bottle," said Citigroup convertible analyst Adrian Miller in a separate report.

"Consequently, individual valuation concerns took a back seat to momentum investing, which is usually the investment strategy of choice within the hedge community."

Retreat began around Jan. 26

The markets began to retreat in the last week of January as consumer confidence was reported far below consensus, Miller said, and the decline was fueled further by the release of FOMC comments. Thus, by month's end, many indices had given back nearly half of their gains.

With 10 months of positive results as a tailwind, the convertible market posted a cap-weighted advance of 3.2%, he said, while the underlying stocks jumped 6.1%.

By comparison, he noted that in January the S&P 500 gained 1.8%, the Wilshire 5000 rose 2.1%, the Russell 2000 added 4.3% and the Nasdaq was up 3.1%.

On the fixed-income front, he noted the Treasury market improved with a 1.3% advance, and credit spreads narrowed, resulting in high-grade bond returns of 0.8% and high-yield bonds gains of 1.7%.

"As the convertible market's underlying stocks advanced strongly, the market's weighted average delta improved, albeit not as much as one might think," Miller said.

At the end of the month, he said the convertible market's delta was 55.8%, up from the prior month's 54.6%. Among cash-paying convertible bonds, he said the delta was 60.1%, up from 59.2% at the end of December.

Sometime in first quarter, Miller believes there will be a sharp market correction and resultant spike in volatility.

Correction, volatility spike seen

"We feel that the unidirectional nature of this current bull market has contributed significantly to the decline in both implied and historical volatility from historical highs 15 months ago to their current eight-year lows," Miller said.

"However, we expect a more usual correction of 5% or more to occur sometime this quarter, and with it, an increase in volatility."

He added, "Downward price and upward volatility pressure could also result in the near term from first quarter earnings disappointments."

As of the end of January, he noted that fourth quarter 2003 earnings of S&P 500 companies were estimated to be 25.5% higher than those of fourth quarter 2002, compared to the Dec. 1 estimate of 21.8%.

Over two-thirds of the S&P 500 companies that have so far reported fourth quarter earnings have exceeded estimates, he added, also pointing out that first quarter 2004 growth estimates have increased from 12.5% on Oct. 1 of last year to 13.4% on Jan. 30.

"We believe that the numerous positive surprises of the last few quarters could encourage analysts to raise their first quarter estimates significantly higher," Miller said.

"If companies fail to meet these loftier expectations, the market could react negatively, and volatility could experience a sharp increase."

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