Convertibles rose 2.1%, credit spreads widened and volatility rose, Lehman Bothers says

By Evan Weinberger

New York, Nov. 5 - Convertibles issued by companies in the basic industry sector led the way as the convertibles market generated more than a 2% return for October, Lehman Brothers convertibles analysts said in a report released Monday.

Credit spreads widened toward the end of the month as shaky earnings and credit concerns rose, and, looking at investment-grade convertibles with more than a year of call protection, implied volatility was up nearly 2%.

Convertibles returns grew 2.13% in October. For the year, outright investors have reaped a gain of 10.82% and risk-arb investors have added between 4.5% and 5% to their coffers, analysts Brendan Lynch and Venu Krishna wrote.

The October gains were led by the basic industry sector, which added 7.7% on metal price increases. Weakness in the telecommunications sector drove communications-issued convertibles down 2.1% and energy-issued convertibles slipped 1.4% overall.

Among convertibles closely followed by Lehman Brothers, Itron Inc.'s 2.5% convertible senior subordinated notes due Aug. 1, 2026 performed the best with a 13.4% return versus a15.5% gain in the common stock. For the year, those convertibles are up 66.7% versus a 107.3% rise in the common stock.

On the flip side, E*Trade Financial Corp.'s 6.125% common equity unites due Nov. 18, 2008 lost 9.5% versus a 14.6% loss in the common stock. For the year, the E*Trade convertibles are down 43.5% versus a 50.3% fall in the common stock.

For the year, the highest returning sectors are basic industry, at 53.9%, and capital goods, at 24.9%. Financials continued to bring up the rear, returning a meager 0.6% on investment for the year, the analysts wrote.

Intermediate-grade convertibles were up 2.2% and speculative-grade convertibles rose 3.5%, outperforming investment-grade convertibles, which gained 1.8%. October marked the second consecutive month where intermediate and speculative convertibles outperformed investment grade.

Credit spreads continued to widen in October. "Credit spreads reversed in the second half of the month after briefly tightening early on, following a slew of weak earnings reports and reemerging credit concerns," Krishna and Lynch wrote. The credit spreads for noninvestment-grade convertible bonds closed October at 456 basis points. The spread had been as tight as 430 bps on Oct. 15.

Implied volatility for investment grade convertibles with at least one year of call protection remaining rose 1.7 points to 28.5% in October. Option surface volatility rose 2.2 points to 29.1% in October. The VIX rose 0.5 points to 18.5%, the analysts wrote.

The spread between implied and option surface volatility slipped 0.6 points in October compared to a flat close in September.

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