Deutsche: Year-end sell-off in converts targets financials that may now be oversold

By Ronda Fears

Nashville, Tenn., Dec. 18 - The traditional end-of-year decline in convertible valuations as investors and market makers lighten inventories ahead of year-end seems to have been concentrated in financial convertibles this year, Deutsche Banc Alex. Brown convertible analysts Jeremy Howard and Jonathan Cohen said in a report Tuesday. The situation has been complicated by the general sell-off in the underlying stocks and clouded by a sell-off in the bond market, but the analysts suggest the sell-off may have gone too far.

"There can be little doubt that the financial sector has seen the most aggressive valuation selling. But with the potential for credit surprises during the fourth quarter reporting season, we suggest that the sell-off may have gone too far in the short term," the analysts said in the report.

"Financial convertibles have suffered disproportionately from the traditional year end valuation sell off this December."

The analysts pointed out, however, that the situation has made the valuations more appealing, and noted that since Sept. 11 the implied volatilities on financial convertibles have come in significantly.

"We believe that investors have sold this sector on the belief that the volatility in the underlying shares is likely to decline further from current levels," the analysts said. "Although there is some evidence in the longer dated volatility markets to support this view, we believe that there are short-term catalysts for volatility that may be being overlooked by the market."

In a report Monday on banks, Deutsche equity analyst George A Bicher said there were mixed results expected for fourth quarter and the potential for "surprise" credit quality write-offs is above average. Whether items surface that undermine earnings expectations for 2002 will be a key issue, Bicher said, saying he was revising selected fourth quarter estimates to reflect rising credit costs.

"Most companies in our universe have share prices fully incorporating available good news. We remain near-term cautious ahead of earnings given the likelihood of less favorable news," the convertible analysts said.

"If our fundamental view is correct, and Q4 numbers do indeed contain surprises, the volatility implied by the convertibles in our universe following the recent sell out may prove to be too low in the short term."

The convertibles in question are XL Capital Ltd.'s zero-coupon convertible due 2021, American International Group's zero-coupon convertible due 2031, Stilwell Financial's zero-coupon convertible due 2031, USBancorp's zero-coupon convertible due 2021, Merrill Lynch's zero-coupon convertible due 2031, Legg Mason's zero-coupon convertible due 2031 and the Neuberger Berman zero-coupon convertible due 2021.

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