Citigroup notes higher rates, wider spreads cut into convertible returns

By Ronda Fears

Nashville, Aug. 4 - Convertibles' performance leverage continued to wane in July as high yield spreads widened 46 basis points on average and volatility fell another 11%, said Citigroup analyst Adrian Miller in a report Monday.

"After feeling the pain of a decline in equity volatility, convertibles saw the second shoe drop as interest rates spiked higher and spreads widened," Miller said.

For the month, convertibles returned 0.4% while their underlying stocks returned 3.3%. The major stock indices also posted gains - S&P 500 up 1.8%, Russell 2000 up 6.2%, Nasdaq up 6.9% and the Dow Jones Industrial Average up 2.9% - while bond returns fell. Investment-grade bonds were down 3.8%, high yield off 1.5% and Treasuries lost 7.5%.

Year-to-date, however, convertibles are still performing fairly well, up 14.8% against a 29.6% rise in the underlying stocks.

While the advance in equity prices led to an increase in the convertible market's weighted average delta to 51.1%, Miller noted that the fall off in the market's bond floor caused its premium to investment values to push out to 41.8% from last month's 37.0%, implying an increase in downside risk.

All convertible security types produced uneventful results, he said.

Preferred stocks were particularly hampered due to large exposure in the auto sector and other large consumer cyclical names. Among the four types - zeros, cash-paying, mandatory and preferreds - preferreds were the only convertible security type in negative territory for the month, down 1.05%

After four consecutive months of impressive results, utilities final gave back some of their gains and oil service names led the energy sector lower. The biggest sector gain for the month of July was in capital goods, up 3.09%.

Utilities lost 3.42% in July, while energy was down 2.22% for the month. Consumer staples were firmly on negative ground, too, down 1.31% for July and consumer cyclicals and communications equipment and services were also lower.

"With the torrid new issue pace continuing, coupled with positive performance results, the convertible market's overall market size has spiked," Miller said, growing to $272.9 billion in July from $211.3 billion in December.

With underlying stocks continuing higher, the weighted average delta for convertibles ticked up to 51.1%. For cash-paying converts, the weighted average delta was 56.4% at the end of July.

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