Convertible pros ask about busted issues, callable names vis-à-vis interest rates: Lehman analyst

By Ronda Fears

Nashville, June 18 - The Rho segmentation of busted versus typical issues and callable names were the focus of attention among convertible professionals participating in the Lehman Brothers convertible research team's conference call on the impact of higher interest rates to the market, said Venu Krishna, head of U.S. convertible research at Lehman.

Participation was quite good with 65 clients, Krishna said, noting the call was held on a Friday, which is typically slow for the market, and the summer travel season is under way. There was about 20 minutes of questions and answers, he said, and a lot of one-on-one requests.

"Clearly, people care a lot," Krishna said. "I am very happy with the feedback."

The 41-page report went beyond a routine look at the historical impact of a rising interest rate environment. In addition to looking at the performance of equity markets and credit spreads, the analysts also looked at call risk and volatility markets during those periods.

Duration most important

On a macro basis, the Lehman convertible analysts estimated 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 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. Variations in coupon, credit spread and volatility, however, did not result in very different valuation declines, the report showed.

The profile/type of convertible 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%.

The analysts pointed out, however, that for the longer duration equity sensitive convertibles a higher spread did lead to a meaningfully lower valuation decline of 1.81% versus 2.62% for the lower spread set.

Tough Rho to hoe

As many Greek-freaks in the convertible universe know, the Rho factor, which quantifies interest rate risk of a security, can be a complicated application in this asset class and widely different outcomes can result.

Rho is "a good starting point" to evaluate rising interest rate risk for individual securities or a portfolio, Krishna said, but an important shortcoming is that it does not account for potential interest-rate related changes in other key inputs that are likely to affect valuation.

The Lehman analysts ran 48 different scenario combinations from the inputs - profile, coupon, time to maturity, volatility and credit spread.

For each scenario combination, the analysts calculated the theoretical value, bond value and Rho and then ran the scenario again with a positive 100 basis points parallel shift applied to the interest rate curve, then normalized the theoretical and analyzed interest rate sensitivity of the bonds to each of the five input points.

The theoretical Rho generated by the model on average overstated the actual Rho by 5.77%, the Lehman analysts noted, because of convexity. While the variance was not much on average, on a case-by-case basis analysts said theoretical Rho overstated actual Rho from as little as 4.3% to as much as 19.3%.

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