Salomon analyst suggests short-term convertibles

By Ronda Fears

Nashville, Tenn., April 16 - While many convertible managers have indirectly lowered their interest rate risk over the past two years, Salomon Smith Barney convertible analyst Adrian Miller said investors should re-evaluate their portfolios from the standpoint of duration risk to shorten maturity terms to three years or less.

"Some fixed managers would argue that in the face of an improving corporate earnings environment and narrowing spreads one should lengthen the portfolio's duration," Miller said in a report Tuesday.

"However we would argue that under a cloud of uncertainty surrounding the Fed's expected rate actions, accounting issues whether real or perceived and the uncertainty by investors relating to skittishness toward the pace of the earnings recovery, there remains significant duration risk. At least until visibility around the earnings front and Fed action becomes clearer."

Prospects of corporate spread tightening, growth in corporate earnings and the potential for Fed raising interest rates make up the argument to reduce duration risk, Miller said.

One of the best means of shortening maturities is to pick convertibles with puts in the next three years, and there is a huge list of those, he pointed out. Then, there are other bonds without puts that mature in the next three years that are worth looking at, he said.

Miller came up with a list of nearly 80 convertibles he suggests investors look at to shorten duration exposure. In some cases, he pointed out, significant credit work would be required prior to investing in some of these issues.

With the backdrop of an improving economy and a rising interest rate environment, many fixed income managers use non-spread products like U.S. Treasuries while others who are required to use spread products like corporates will gravitate toward the short end of the curve to own the excess yield and defend against rising rates.

"Naturally, this rotation will cause spreads to come in further thereby taking much of the cheapness out of the short end of the curve," Miller said.

"As the convertible market has sold off over the last couple of years and premiums have ballooned and deltas have collapsed, the convertible bond market has found that there is an increasing amount of duration risk or fixed income risk built into the market."

Since convertible cash-pay and zero-coupon bonds with weighted average premiums of 63% and 55%, respectively, make up some 73% of the market, many convertible investors are faced with a portfolio that is behaving a lot more like a fixed income portfolio than an equity linked portfolio. As such, they have seen their exposure to interest rate movements increase measurably.

But due to the onslaught of zero-coupon and O.I.D. convertibles new issues over the last couple of years with short term puts, Miller said, the magnitude of increasing duration risk has been mitigated to some degree.

"As a result of this increased exposure, we believe it may be prudent to shorten the duration of investor's convertible bond portfolios with the increased exposure to either short maturity convertible bonds or convertibles which offer a short term put," Miller said.

"In other words, investors should look to invest in cash equivalent convertible securities whose yield-to-put or yield-to-maturity would capture a market rate of return for a similar duration security. In the case of our analysis, we are focusing on duration of 3 year or less."

High-grade corporate spreads have begun to narrow, the analyst pointed out, as consistent improvement in economic data has supported increased expectations for improved earnings by the second half of the year. Salomon's current 2002 and 2003 earnings growth estimates are for an increase of 7.5% and 13.3%, respectively.

Salomon economists right now project a 25 basis points increase in interest rates in June, followed by small steps in the remaining four Fed meetings, anticipating Fed Funds will settle in at the 3.0% range at yearend.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.