Merrill sees opportunity in high vega convertibles over the summer

By Ronda Fears

Nashville, June 2 - Convertibles will cheapen over the summer as volatility subsides, offering investors an opportunity to pick up some high vega issues before they begin to richen after the season ends, according to Yaw Debrah, director of U.S. convertible research at Merrill Lynch & Co.

Merrill's volatility index regression model estimates a VIX level of 29.6% as of May 29, which is 7.3% wider than the 22.3% currently seen in the market.

"We consider this difference to be excessive," Debrah said in the report, which included contributions from Christopher Garman, high yield strategist at Merrill, and Benjamin Bowler, who along with Debrah is co-head of global equity-linked research at Merrill.

"We believe that this gap will close as we come out of summer or if there is a market shock prior to then.

"In the short run, as we traverse through the potentially quiet summer months, in the absence of some market shock, we would expect market volatility to overshoot on the downside and the VIX to approach the 20% level.

"We believe that this would be a good level to accumulate positions. In our opinion, this would present an opportunity for investors to pick up cheap convertibles, which we would expect to see richen as we come out of the summer months."

In the medium term, Merrill is looking for a VIX level of 27.3% by year-end 2003 - a 5.3% increase over the current actual VIX level of 22.2% - and that may be low in the event of market shocks.

"In the convertible market place, valuations continue to be rich because though implied volatility has declined in recent weeks it is still at elevated levels compared to realized volatility in the equity market place," Debrah said.

"Though implied volatility in the convertible market has declined recently, the rate of decline is substantially less than that of the VIX, leading to largest divergence in convertible implied volatility and the VIX since we started tracking this data at the beginning of 2000."

Convertibles with the highest vegas could offer investors particular opportunity to capitalize on the dip. The vega of a convertible bond is the change in bond value for a one percentage point change in equity volatility.

"Investors should keep these convertibles on their radar screen during the quiet summer months with a view to benefiting from higher volatility as we come out of the summer months," Debrah said.

The major risks to the forecast are a significant terrorist strike on the U.S. homeland or foreign exchange crisis, he noted.

"Keep an eye on exchange rates," Debrah advised.

"Dollar weakness up to now has not been perceived as a major issue for either the U.S. or European economies, but an accelerating rate of depreciation could be a factor in spooking the markets."

The top five vega converts with cash coupons (vega in parentheses) are Teva Pharmaceuticals' 0.375% due 2022 (0.716), HCC Insurance's 1.3% due 2023 (0.710), Zenith National Insurance's 5.75% due 2023 (0.682), Aon's 3.5% due 2012 (0.673) and Interpublic Group's 4.5% due 2023 (0.663).

The top five vega converts with 0% coupons (vega in parentheses) include Silicon Valley Bancshares due 2008 (0.611), Yahoo due 2008 (0.559), Comverse Technology due 2023 (0.531), Allergan due 2022 (0.529) and Countrywide due 2031 (0.476).

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