Outlook 2013: Lower returns seen after 'solid' 2012; rates a headwind; selection of paper eyed

By Rebecca Melvin

New York, Dec. 31 - The convertible bond market is seen as fairly valued heading into the new year, and performance in the secondary market is expected to remain steady or slip following solid performance in 2012, market players said.

Last year at this time, the market was seen slightly cheap.

The downward expectation for returns is based on a more muted forecast for U.S. equities compared to 2012 and less room for credit valuation expansion.

Barclays predicts an outright return of 6.5% in 2013, using its base-case scenario, which is down from an outright return of 13.4% in 2012 as of early December.

Aviva Investors, which evaluated the market globally, also predicts convertible returns will appreciate by "mid-single digits" in 2013 as per its base-case forecast.

The return will be driven by modest gains in equity markets and interest payments, and takes into account the influence of credit markets, which is expected to be minimal in the coming year, Aviva said in its December Market Edge report.

Underpinning Aviva's outlook is the expectation that signs of gradual recovery in the global economy will continue given recent data, but macro factors, including the European debt situation and uncertain U.S. fiscal policy, remain potentially significant problems for the convertibles market.

In addition, there might be some unanticipated macro issue that actually zaps the market, one convertibles analyst said. "It's usually something unexpected," he said, mentioning, for example, debt troubles brewing in Japan. It's not clear when that trouble might come to a head, but something could happen in 2013 or 2014, he said.

Ninety percent of Japanese sovereign debt is held by the Japanese public, many of whom are expected to sell off a part of their holdings to pay for expenses in retirement, he said.

Hedged returns seen lower

Hedged returns, which are more dependent on valuation and credit, are also expected to come in below 2012, when the return was 5% to 7%, sources said.

Convertible arbitrage was up 6.29% for the year to date, according to hedge fund research, reversing a 3% decline in 2011.

Barclays called the returns "attractive" relative to high-yield straight debt, investment-grade debt, equities and Treasuries.

Barring a jolt from U.S. fiscal policy, another crisis in European debt, or some unforeseen shock, something akin to the returns of 2012 could be attained in the coming year, analysts indicated.

A continued low level of new issuance through 2013 will continue, however, and that will hamper the market and could threaten the supply/demand balance and performance, Aviva's global convertibles research analyst Brendan Ryan wrote.

New supply in the U.S. fell to a decade low in 2012 to only $21.89 billion in new issuance priced during the year, compared to $25.95 billion of new issuance in 2011, and compared to $40 billion to $60 billion, which the market is capable of achieving and which has been notched during good years in the convert space in the past, according to Prospect News' data.

The single biggest headwind for the convert market and new issuance is the low, near-zero rates being maintained by monetary policy, market sources said. In the low-rate environment, issuers are encouraged to tap other markets like high-yield to raise capital instead of convertibles because they can do so at low rates without involving their underlying shares.

Given current policy, which aims to keep rates at near zero until unemployment drops to 6.5%, most sources said they expect new convertibles issuance to remain at the current depressed level through 2013 or at best tack on a 5% to 10% increase. One outlier forecast put new issuance higher by as much as 35% at $30 billion for the coming year, however.

Barclays' base case, 6.5% outright return assumes tepid to moderate economic growth including U.S. GDP growth of 2.1%, unchanged rates, 4% to 6% return for the high-yield debt market, 4.25% return for investment-grade debt market , 8% to 10% return for equity and a year-end S&P 500 target of 1525.

But if equities moved up by more than 8% to 10%, then a higher outright return for convertibles is seen. Against a positive 15% equity move, the total return for convertibles would be 8.7% over the one-year period. On the other hand, if equity drops 10%, then the estimated total loss for convertibles is 2.6% over the period, according to Barclays.

Hedged returns will also be hampered by static valuation improvements due to credit spreads being at fairly tight levels; but, the expectation for Treasuries and other debt markets is also low.

In light of these tight spreads, no contribution from improved credit is expected, Barclays convertibles analysts Venu Krishna, Manoj Shivdasani and Piyush Anchliya wrote in their 2013 convertibles outlook report, called "Ready to Bat."

2012 returns 'solid'

Compared to the more "see saw" action of the recent past, the transition to 2013 from 2012 is expected to be pretty smooth. For example, hedged returns for 2009 surged to 34% to 39%, following the financial meltdown of 2008. And the hedged return in 2011 fell to negative 2% to 3%, compared to 9% to 10% in 2010.

Furthermore, the 2012 outright return for convertibles outperformed investment-grade debt, which returned 10.2%, but it underperformed the high-yield market, which returned 14.9%. It also outperformed seven- to 10-year Treasuries, which returned 5.3%, according to Barclays' data.

It also underperformed equities, but sources said that is to be expected because issuers of convertible debt carry more risk taken as a whole, compared to the overall universe of stocks.

In addition, the hedged returns racked up in 2012 were consistent with prior years and that is how the hedged community likes to have them, a Chicago-based trader pointed out.

"If equities are up 15%, you want 9%," the trader said, and anecdotally returns for hedged players ranged from the mid to upper single digits.

"It's two totally different asset classes, the trader said, adding that hedged returns were "OK" and "nobody will be disappointed."

Keeping the community satisfied is important to retain fund flows, and as of now invested capital has been remarkably consistent.

Total assets under management were up slightly at $42 billion from $40 billion, largely reflecting performance in 2012, although outright investors saw marginal flows constrained by low primary market activity.

Fund flows into convertible arbitrage hedge funds were negative $200 million, which was down from a positive $600 million in 2011, according to HRFX Hedge Fund Research.

Asset flow from retail investors into convertibles continued to grow in 2012 as measured by the SPDR Barclays Convertible Securities ETF. The ETF's assets under management are about $855 million, which was up 25.6% as of early December, and the number of shares outstanding has grown to 21.5 million, which is up 14% for the year, according to Barclays.

Preferreds, financials excel

Within the asset class, preferred structures returned 21%, convertible bonds of small-cap companies returned 15.8%, and convertibles of mid-cap companies returned 14.3%, while convertibles of non-investment grade companies returned 15.9%.

Of the preferreds, financials did particularly well with the Bank of America 7.25% convertible preferred rising 51% as of early December and the Wells Fargo preferred up nearly 23%.

Other equity sensitive names were affected more by intra-year swings. From April to August, the equity markets came off, giving up most of their early year gains. Then on the back of the third round of quantitative easing, there was a long rally. Finally after the U.S. elections in November, pessimism returned.

Mandatory convertibles ended with a 12.9% return, which was in line with the broader convertible market. But there were some twists and turns along with way. In the early part of the year, mandatories outperformed, before significantly underperforming during the overall sell-off. Then they finally recovered with the last equity rally. The result contrasts with 2011, when the mandatory structure lost 22.4%.

The year was "unexciting," from the perspective of credit, a Connecticut-based distressed convertibles trader said, adding that there were no large swings in valuations, and "in general, the arb community benefited from a bid on lack of supply and the advantage of owning the secondary market."

Spreads, meanwhile, compressed during the April to August period from a peak of 695 basis points over benchmark for high-yield debt as of June 5, to 513 bps for high yield as of Sept. 14.

And with the market now more or less at fair value - although high-yield converts are slightly cheap - there is a lower cushion if negative macro events play out. The whole market was seen 1.5% cheap at the beginning of 2012.

Tilting toward higher risk

Meanwhile, new issuers have been tilting more toward higher beta than in the past.

But the asset class as a whole sports an attractive blend of income with a 3.4% current yield, risk-controlled equity exposure that is effectively 47% and relatively short duration of 3.4 years, according to Barclays.

There are 6% less balanced convertibles, which returned 12.2% in 2012 compared to a 2.7% loss in 2011, and they comprise 32% of the market. There are also fewer busted convertibles and equity sensitive names, which returned 15.2% this year from a 7.1% loss in 2011.

As far as pricing goes, the lion's share of distribution of issues is in the 90 to 110 range.

The average convertible bond price is 111.8% and terms in the market average 4% coupon with a 38% premium and 47% delta. This affords an attractive combination of yield, equity exposure and downside protection, Barclays said.

The market became more equity sensitive after the 2012 equity rally, but it is still diverse enough to find opportunities, sources said.

Positive plays of 2012

Amgen Inc.'s large, liquid convertible bond, which matures in 2013, ran up to about 114 from par in the past year, following its underlying shares higher. Early in 2012 it shifted to a volatility play as it moved, compared to how it previously traded as a cash surrogate. Shares of the Thousand Oaks, Calif.-based biotechnology giant ran up to about $90 from $60 in one year.

News in VeriSign Inc. at the end of October and start of November caused its longer-dated convertibles to fall outright but edge higher on a dollar-neutral, or hedged, basis after news that regulators delayed review of a contract under which the registry of Web domain names operates. The convertibles added a little more on hedge later after the company announced that the contract was approved but with restrictions on VeriSign as to its ability to raise prices.

Clearwire Corp. moved up to about the 111 mark from the 60s. The latest move was on news that Sprint Nextel Corp. has bid for the other half of the company that it doesn't already own.

Clearwire's 8.25% convertibles due 2014 zoomed up from about 60 - the mid 60s at midyear - while the underlying shares of the Bellevue, Wash.-based wireless broadband services provider moved between $0.83 to $3.40 in the last 52 weeks. Shares were last at $2.90.

"If you bought it at the right time it was a great play," a New York-based analyst said of Clearwire.

A name similar to Clearwire was Knight Capital Group Inc. The Jersey City, N.J.-based electronic trading firm received a bid this week from rival Getco Holdings Co. LLC in a cash and stock deal that values the company at $1.4 billion. The news sent the convertibles to near par. They had dropped in to the 40s in August when the company was roiled by a technology glitch that cost it $400 million and nearly pushed it into bankruptcy.

"It made a great play if you bought in the 40s and get taken out at par," the analyst said.

AMR Corp., which filed for bankruptcy protection in November 2011, is another winner. It's benchmark 6.25% convertibles due 2014 traded last right around 86.50, which was up from a plunge to 15 shortly after its bankruptcy. Its trajectory higher in the past year came amid speculation that it will emerge as a successful carrier again, potentially as a partner of US Airways.

But moves in distressed names were anything but predictable. The convertibles of bankrupt A123 Systems Inc. were in the 30s but are now is in the 60s. Patriot Coal Corp., which filed for bankruptcy protection in July, fell to 15 from par and has been quiet recently, now trading around 14.

THQ Inc. filed for bankruptcy protection right before Christmas and those convertibles were active but barely moved in price, having slumped to 11 bid, 12 offered amid the darkening clouds for the company.

In December 2011 the THQ 5% convertibles dropped from the upper 80s to the upper 70s on a downgrade in which the analyst cited the video game publisher's likelihood of missing guidance due to underperformance of its uDraw video game.

The outlook isn't bright for video game publishers. "Look at Activision. They don't have converts, but the stock has been weak," a New York-based trader said, citing renewed concern about video game violence in the aftermath of the heart breaking school shooting in Newtown, Conn., on Dec. 14.

Portfolio performance depends on avoiding such pitfalls. In 2012 defaults that impacted returns of convertibles portfolios included those of Delta Petroleum Corp., China Medical Technologies Inc., Patriot Coal Corp., ATP Oil & Gas Corp. and KV Pharmaceuticals.

American Oriental Bioengineering Inc., Eastman Kodak Co., Petroplus Holdings and A123 Systems Inc. also affected convertibles players when they declared bankruptcy.

On the new issue front, players were able to do really well on first-day trading in many names. Tibco Software Inc., which priced last April, has since dropped outright to about 94 bid, 94.50 versus an underlying share price of $21.80, but on a dollar-neutral, or hedged, basis, players have made money on the issue using a delta hedge of about 30%.

Shrinking market, liquidity

The universe of convertibles has been shrinking for several years as depressed levels of new issuance fail to keep pace with tenders, maturities and other redemptions.

In 2012, the portfolio of Barclays' U.S. convertible composite index consisted of 520 securities with average terms of 4% yield, 38% premium and a market value of about $208 billion, or face value of about $203 billion. Another source saw the face value of the universe of convertible bonds below $200 billion.

The "incredible shrinking market" theme is not a new one. Liquidity has been declining for several years, but the trend is not just affecting the convertible bond market, but all markets, sources said.

In fact, the decline in convert market liquidity this past year wasn't as great as it was in the high-yield market. Looking at the daily volume of convertibles changing hands via Trace data versus its outstanding face value shows that its lower rate of liquidity wasn't as steep as it was in the high-yield bond market this past year, according to Barclays.

"But liquidity is on a name by name basis. Do we make real live markets in converts, yes. Do we make them in every convert, no," a New York-based convertibles analyst said.

In addition to the new issue/redemption imbalance, the analyst cited the fact that there are fewer hedge funds in the market now compared to 2007, when they accounted for 75% of the investor profile.

Currently the investor profile is at 52% outright, 48% hedged, having edged slightly toward outright investors this past year, Barclays said.

Immediately after the financial crisis, the profile was seen to have shifted to about 50-50 outright versus hedged participation.

With more outright participation, liquidity becomes more of an issue because outright players tend to hold onto the paper for longer periods given they are looking at fundamentals, and hedged players are more likely to rotate their holdings.

Hedged guys are typically prone to turn over their positions, compared to outrights that sit on it, "so you're going to have less liquidity definitely compared to five years ago," the analyst said.

A second source said lower liquidity, which makes it more difficult to buy or sell securities, is a more obvious issue now because the asset class is quite small. But on balance, it's not lower, but flat, he pointed out, because there is no new money coming into the strategy in serious quantities.

Factors like increased regulatory uncertainty for broker-dealers, lower hedge fund participation, modest leverage deployed, tepid new issuance, small deal sizes and a shrinking convertible market have put increased pressure on secondary market liquidity.

The good news is that there are no big outflows either. "Funds have the cash, and its' going to be fine," the Chicago-based trader said. There are convert hedge fund opportunities across the board, he said. But opportunity in new issuance is the thing that is holding investors back. "We need the pendulum to swing back," he said, referring to 2007 when new issuance in convertibles peaked at $97 billion, according to Prospect News' data.

For the cycle to turn back, sources agree, there needs to be a combination of widening spreads, rising equity prices, and rising rates, which are typically the easiest indicator to identify. Catalysts for rising rates are not expected for a year or more, but fingers are crossed for positive trends in the other two areas in 2013.

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