Stock picking, not derivative markets, drives convertible gains in October, Citigroup says

By Peter Heap

New York, Nov. 7 - Convertibles gained 3.4% on a capitalization-weighted basis in October, with results driven by stock picking rather than derivative markets, according to Citigroup convertible analyst Adrian Miller.

The return on convertibles compares with a 6.6% gain on the underlying stocks.

"With spread and volatility influence at a minimum, convertibles actually performed as one may have thought given the market's overall level of weighted delta," Miller wrote in his report on the month.

"It has been a long time since the performance of the convertible market was not materially affected by the associated factors such as changes in volatility and credit spreads. While we did see volatility continue to decline and high yield corporate spreads contract throughout October, these factors had less impact on convertible valuations and therefore returns than has been the case in previous months."

Volatility continued to be weak during the month. The VIX index fell to 16.1% on Oct. 31 from a 24-week high of 22.2% on Sept. 26.

But Miller said convertibles had already priced in weakness because of the plunge in volatility in June, so the price impact was no more than a quarter or half a point on vega names.

On the credit side, high-yield spreads contracted 72 basis points in the month, but a 40 basis points rise in the Treasury curve offset much of the move. With only around 35% to 40% of the market sensitive to credit spreads, the overall impact on convertible performance in the month was "minimal," Miller said.

Meanwhile, new issuance has slowed from the "blistering pace" earlier in the year.

As a result, secondary trading - and market returns - has largely been driven by earnings and merger and acquisition announcements, Miller said.

Indicating the lesser importance of derivative markets in the month, outright convertible investors returned 4.2% in the month while convertible arbitrage players achieved 2.8%, according to Citigroup estimates.

With convertibles' gain, the market's equity sensitivity increased. The proportion considered equity sensitive rose to 39.6% from 38.1% the month before.

The credit sensitive sector also grew to 35.0% from 38.1% due to weakness in some large capitalization names such as Sprint PCS, Citigroup said.

The weighted average delta rose to 51.6% from 50.5% during the month while the weighted average conversion premium fell to 50.0% from 52.9%.

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