Merrill: Mandatories erase benefits of "new issue effect"

By Ronda Fears

Nashville, Tenn., July 3 - Due to the higher equity sensitivity of mandatory convertibles and the current climate of declining stocks, the so-called "new issue effect" was erased in second quarter despite a relatively strong calendar.

"Due to the equity sensitivity of the new mandatories, in a down market the new issue effect, where new issues typically outperform the secondary market, was virtually erased during second quarter," said Merrill Lynch & Co. convertible analysts Yaw Debrah and Tatyana Hube in a report Wednesday.

Although the Merrill convertible new issue index held up quite well, declining 8.2% for second quarter, versus a 20.3% decline in the underlying equities, the analysts noted that new issue performance was worse than the 7.6% decline for Merrill's entire U.S. convertible index in the quarter.

Although the primary convertible market remained open in June, the pace of new issuance in 2002 has slowed significantly. But the Merrill analysts note that net issuance remained positive and relatively high at $22.7 billion year-to-date, as more issues came to market than were redeemed.

Terms have begun to swing more to the favor of buyers, the analysts showed. Average yield at-issue increased substantially to 7.4% in June from 4.8% in May, while the average initial conversion premium decreased slightly to 25% in June from 26% in May.

That was chiefly due to the continuing influx of mandatories, which also diminished new issue performance in the secondary market as stocks remain in a southerly trend.

"The increased number of mandatories also affected the average equity sensitivity of new issues," the analysts said.

"The average parity delta of new issues increased from 0.7 in May to 0.8 in June. Typically, during market downturns, this sensitivity translates into greater downside risk in the performance of converts."

Otherwise, the analysts noted the deteriorating equity markets have had a negative effect on the market for new convertible issues, as issuers seem to be waiting on the sidelines for higher equity prices.

In June 2002, there were 11 deals priced with total market value of $3.3 billion, compared to $6.3 billion in June 2001. For the first half of the year, there was a total of $41.9 billion new issues, versus $56.4 billion in the first half of 2001.

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