Lehman: Convertibles overall would drop 1.73% on a 100 bps shift in Treasury curve

By Ronda Fears

Nashville, June 16 - On a macro basis, Lehman Brothers convertible analysts say the convertible market is better insulated against interest rate hikes than one might expect. In a report Wednesday, the analysts estimate the negative valuation impact on the overall convertible market to be 1.73% on a parallel 100 basis point shift in the Treasury curve.

The analysts have scheduled a conference call to discuss the report for 1:30 p.m. ET Thursday.

"Broadly speaking, our analysis demonstrates that shorter maturity securities which fall under the equity sensitive and typical segments, are best positioned while longer maturity busted securities are the worst positioned," the analysts said in the report.

"Not surprisingly, floaters have a positive interest rate exposure, while preferreds as a group possess the greatest negative exposure."

In addition to looking at interest rate hike periods of the past and the performance of equity markets, credit spreads and volatility markets during those periods, the analysts also looked at the issue of call risk. They noted, too, that they used the premise of a Federal Funds rate hike to 2% by year-end, versus the current 1%.

Duration biggest factor

The time to maturity was the most sensitive factor, the analysts found, with their analysis showing five-year maturity bonds dropped 3.13% while the two-year maturity bonds lost 1.46% in value.

The profile/type of convertible also contributed meaningful differences in valuation decline. As would be expected, the busted set declined the most by 2.98%, followed by typical converts that lost 2.25% in value, while the equity-sensitive group lost 1.66%.

Variations in coupon, credit spread and volatility, however, did not result in very different valuation declines, the report showed.

"The highest risk converts are the longer maturity busted ones with the risk dropping a bit for the longer duration typical and equity sensitive sets," the analysts said in the report.

"The least affected set was the shorter duration equity-sensitive set followed by the shorter duration typical and busted convert sets."

They added, "It is interesting to note that for the longer duration equity-sensitive converts a higher spread did in fact lead to a meaningfully lower valuation decline (-1.81% versus - 2.62% for the lower spread set)."

Potential sells

Among long maturity busted convertibles with high interest rate risk, which analysts suggested holders consider selling, the top five listed were the Crescent Real Estate 6.75% perpetual convertible preferred, Hewlett-Packard 0% due 2017, BroadWing 6.75% perpetual convertible preferred, Capstead 11% perpetual convertible preferred and CMS Energy 7.75% due 2027.

Among long maturity typical convertibles with high interest rate risk, which analysts suggested holders consider selling, the top five listed were the Travelers 4.5% due 2032, Northrop Grumman 7% convertible preferred, USX 6.5% perpetual convertible preferred, Emmis 6.25% perpetual convertible preferred and Placer Dome 2.75% due 2023.

Potential buys

Among equity-sensitive convertibles with at least one year of call protection and positive stock or sector fundamentals with low interest rate risk, which analysts suggested holders consider buying, the top five listed were the Flextronics 1% due 2010, RF Micro Devices 1.5% due 2010, Comverse Technology 0% due 2023, American Tower 3.25% due 2010 and Carnival 2% due 2021.

Among convertibles with at least one year of call protection and positive stock fundamentals with low interest rate risk, which analysts suggested holders consider buying, the top five listed were the Franklin Resources 0% due 2031, CSX 0% due 2021, SPX 0% due 2021, Veritas Software 0.25% due 2013 and Weatherford 0% due 2020.

Among the combined list of equity sensitive and short-maturity convertibles in industries expected to outperform in a rising-rate environment, which analysts suggested holders consider buying, the top five listed were the Flextronics 1s, RF Micro Devices 1.5s, Franklin zeros, CSX zeros and SPX zeros.

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