Merrill sees convertible returns of 10% in 2003, absent any geopolitical shock

By Ronda Fears

Nashville, Jan. 7 - Barring shocks from geopolitical or terrorist events, Merrill Lynch & Co. convertible analysts are looking for what they call a slow but steady rebound. On an outright basis, 2003 returns are expected at 10% while hedge funds are seen getting 10% to 12%.

"With an average yield on the market today of about 5%, together with anticipated capital appreciation as spreads in the marketplace improve, we are looking for a total return in the convertible market in 2003 of approximately 10%," said Yaw Debrah, head of U.S. convertible research at Merrill, in a report.

"After an overall return in 2002 of about 4-5%, we are looking for hedge fund returns of about 10%-12% in 2003."

Managers will have to remain on their toes, however. Thus, defensive sectors and defensive issues continue to be the analysts' favorites.

"Convertible managers should be able to take advantage of the convertible market's balance in terms of value/growth, credit quality, size and sector to beat the index," Debrah said.

"The high premium of convertibles provides downside protection, while high yields provide equity like returns."

While geopolitical and terrorist risk exists, he said, 2003 should be a positive year for convertibles, with positive equity markets, spreads decreasing and Treasury curve flattening helping convertible valuations.

Defensive sectors continue to be the Merrill analysts' favorites - consumer staples, energy, utilities, aerospace/defense and industrials, and the major pharmaceutical companies - as they expect those to outperform the market during 2003.

Debrah also said that convertible investors should look to small caps, and noted that high-yield credits are improving.

"This could be the year of convertible small-cap outperformance. Small- and mid-cap convertibles have underperformed large-cap convertibles in the past five years. This trend could potentially be reversed in 2003," he said.

"Declining credit spreads and default rates should be a market positive. If this was to occur, we predict that speculative grade will outperform investment-grade converts, as in 2002."

Yet, a focus on credits, in addition to avoiding blowups, will be crucial for convertible managers to beat the index, he said.

"Active convertible portfolio managers, seeking to use the asset class as a risk averse strategy, benefited as convertibles held up in the face of dropping stock markets," Debrah said.

But, he added: "We believe that earnings expectations are still too high given low nominal GDP growth. Look for more earnings downgrades/disappointments."

Helping active portfolio managers with a credit focus, though, is the busted state of the convertible market.

He noted that the average market delta reached an all-time low on Oct. 9 of 0.26 with the conversion premium at an all-time high of 111.6%.

Currently, he said, about 67% of the U.S. convertible universe is comprised of issues with a delta lower than 0.4.

Thus, Debrah suggested looking for quality yields, begin the new year with an overall delta of 30%, or parity delta of 44% due to the uncertainties related to geopolitical risk and terrorism, play new issues aggressively for equity sensitivity, and diversify in terms of credit, value/growth, market cap, equity sensitivity and across sectors.

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