Merrill notes bias toward higher credit quality in convertibles

By Ronda Fears

Nashville, Tenn., March 6 - There was a bias toward higher credit quality in February as investment-grade convertibles declined 1.8% compared with a 3.8% drop for speculative-grade issues, noted Merrill Lynch & Co. convertible analysts in a report Wednesday. Overall, the group noted that the Merrill convertible universe was off 2.8% for the month against a 7.4% decline for the underlying stocks.

"February showed a bias toward higher credit quality, with investment grade converts down 1.8% vs. a 3.8% drop for speculative grade," said Merrill Lynch director and convertible analyst Shawn Foley in the report.

"This trend was echoed in the debt markets, where high-grade government and corporate bonds rose 0.9% for the month, while high yield fell 1.0%. At the high-quality end of the spectrum, spreads tightened slightly, by approximately 3-5 bps in the AA range. More borderline credits showed marked spread widening, however, by about 10-30 bps in the BBB range. Single-B spreads widened by about 30-40 bps on average."

Looking strictly at the convertible return, very little company size bias was evident for February. Both small cap and mid cap converts fell 2.6%, while large cap dropped 3.0%. However, the underlying stock performance markedly favored the bigger companies with large cap shares down only 6.7% while mid caps fell 8.1% and small caps lost 10.4%.. Small Cap converts' mere 0.27 average delta proved helpful against a difficult month for the smaller, growth-oriented stocks.

Yield converts continued to benefit from defensive qualities, dropping 2.0% whereas total return converts fell 3.8% and equity alternative converts dropped 3.5%. However, Foley noted that, yield converts have been underperforming both high-yield and high-grade straight debt in 2002. Year-to-date, he said, yield converts are down 1.8% versus a 1.4% drop for high yield bonds and a 1.5% gain for high-grade government and corporate bonds.

The U.S. convertible market value dropped from $223.7 billion to $218.8 billion in February, but the analyst noted that since net issuance was positive for the month, the drop was attributable to depreciation.

"The first week in February saw scant new convertible issuance, leading some to conclude the calendar was drying up. However, steam picked up as the month progressed. Not counting the $3+ billion priced after the close Feb. 28, the month brought $4.9 billion in new issuance," Foley said in the report, noting that year-to-date convertible issuance has totaled $15.8 billion in proceeds.

"Against almost $5.0 billion in puts, calls, and voluntary or mandatory conversions, net issuance YTD is $10.9 billion. The first two months of last year had a net issuance total of $14.5 billion."

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