Deutsche advises exiting rich convertibles in anticipation of market cheapening

By Ronda Fears

Nashville, Dec. 3 - Investors should look to exit some over-valued convertible issues, Deutsche Bank Securities Inc. analysts are suggesting.

While the U.S. convertible market enjoyed a strong rebound in October and November, giving a welcome boost to flagging convertible arbitrage returns, the analysts warn the gains are not broadly sustainable.

"We conclude that a significant move to the downside is unlikely before year end," said analysts Jeremy Howard, Jonathan Cohen and Robert Barron in a report Tuesday.

"But we suggest that investors use any further strength between now and the middle of January to lighten positions with high vega and extended valuation. Unfortunately, there are a number of securities in this category."

The analysts identified 19 bonds which they believe are most at risk of a valuation contraction. Those are: Johnson & Johnson 0% 2020, Anadarko Petroleum 0% 2020, First American 4.5% 2008, UPS 1.75% 2007, Avon Products 0% 2020, First Data 2% 2008, Affiliated Computer 3.5% 2006, News Corp. 0% 2021, Teva 1.5% 2005, Brinker 0% 2021, Apogent 2.25% 2021, Kohls 0% 2020, Supervalu 0% 2031, Lowes 0% 2021, Transocean 1.5% 2021, TJX 0% 2021, Teva 0.75% 2021, Arrow Electronics 0% 2021 and 3M 0% 2032.

The analysts noted that many of these 19 at-risk converts are not widely held by hedge funds but could be of interest as short trades.

The strong rebound in valuations has led to three good months for convertible arbitrageurs, but the concern is whether the present "decoupling" of underlying equity and convertible implied volatilities is justified, or whether the ground is being laid for a correction sometime in 2003.

CSFB/Tremont reported convertible arbitrage returns of 1.37% for September and 1.03% for October. Deutsche's unofficial soundings suggest that November will be stronger than either of those two months.

"Our experience in tracking the European market suggests that decoupled patterns such as the one forming in the U.S. can be a sell signal for valuation based investors."

"The continued richening of European convertibles as equity index implieds came down proved to be an excellent exit opportunity from European convertibles in first quarter 2002. Since then, the two markets have tracked each other very closely."

The analysts noted that while DAX and S&P 500 implieds have both come off sharply since October, European convertible valuations have come down in line, whereas U.S. valuations have continued to march higher.

Recent richening of U.S. valuations, the analysts said, is attributable to tightening credit spreads, net inflows into convertible arbitrage funds, the regulatory environment, extra optionality priced into convertibles, the interest rate environment and the general year-end effect.

Current valuations are not sustainable, the analysts said, because equity volatilities are falling as the market recovers, new issuance may be poised to recover, the high-grade "safety premium" may unwind and the regulatory environment could be less helpful in 2003.

The analysts stressed that they only scrutinized convertible bonds. While they believe the basic argument also applies to convertible mandatories, they will be looking at mandatories separately.

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