Hope, strength of convertibles secondary market relies on strong primary market

By Ronda Fears

Nashville, Tenn., Dec. 31 - The convertibles market will open 2002 continuing in a cautious vane, market watchers expect, because of considerable trepidation about stocks. Largely, market onlookers believe the best hope for a recovery in convertible prices will come from a strong new issuance calendar, which spurs secondary trading and can provide strength to the overall market. In a nutshell, 2002 is expected to be another challenging year for convertible returns.

While many believe there will be a strong recovery in stocks as well as the U.S. economy, most are also skeptical that any recovery will be broad-based. The upshot is that because convertibles remain very defensive, and therefore less sensitive to equity spikes, convertibles' participation with any recovery will be only modest. On the flipside, if stocks should continue to slide, the impact to convertibles will be mitigated.

"I can't put a specific number on what I think is going to happen to convertible returns. But if we have a profit recovery, converts will have a lot of exposure," said T. Anne Cox, head of global convertible research at Merrill Lynch & Co.

"Still, I don't think we could keep up with the stock rebound, especially if it's a quick pop."

Equity sensitivity among convertibles has been improving lately, but it still is nowhere near traditional levels.

Salomon Smith Barney convertible research shows that as of Nov. 30, the weighted average percentage of convertibles that are considered equity sensitive increased to 29% from 26% at Oct. 31 and 23% at Sept. 30 but still well off the spike to 73% at the height of the dot.com and telecom bubble. In another measurement of equity sensitivity, Salomon research showed that the weighted average delta of the convertible market drifted higher to 43% at Nov. 30, up from 40% at Oct. 31, but also down from the low 70%s during at top of the bubble.

"As a result of the relatively low delta level and the tiny percentage of issues considered equity sensitive, it is no wonder why convertibles have only achieved 35% of the upside participation. This level is considerably lower than the historical median participation rate of 66%," said Salomon Smith Barney convertible analyst Adrian Miller.

"We can expect the convertible market to continue to lag its underlying stocks on the upside as the market proceeds into the expected 2002 recovery. In addition, we may also see further relative underperformance if the performance breadth begins to narrow. Therefore, while many economists and equity strategists are bullish about the prospects of the markets next year, relative convertible market returns may prove challenging over the next 12 months when compared to other equity asset classes."

In November, the Salomon Smith Barney convertible index rose 3.2%, whereas the underlying stocks had a 9.2% gain. But, convertibles have been in the defensive mode for most of 2001 while stocks were dropping sharply. The Salomon convertible index was off 6.5% year-to-date through the end of November, while the underlying stocks fell a dramatic 21.60%.

Similarly, the Bear Stearns convertible index in November gained 3.39% with the underlying stocks up 9.12%. Year-to-date through Nov. 30, the Bear Stearns convertible index was off 5.68% with the underlying stocks down 18.24%.

"The secondary market is very defensive. The premiums are so high that converts don't participate much with the gains in stocks," said Jeffrey Siedel, head of convertible research at Credit Suisse First Boston.

"I'm not overly optimistic on equity recovery. I'm not overly bullish on convertible returns, but there are opportunities. There is a lot of investment-grade paper with putable structures. Maybe investors just start going for yield. There are pockets of opportunities, but not a lot. What will help the secondary market is a strong new issues market."

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