Citigroup analyst: Estimates for convertible returns expected to hold up in rising rate environment

By Ronda Fears

Nashville, April 21 - If 10-year Treasury rates rose to a 4.75% to 5.00% level by year-end, convertible market returns should still come in at the high-single-digit to low-double-digit neighborhood as previously estimated, said Citigroup Global Markets Inc. convertible analyst Adrian Miller in a special report Wednesday.

"In a 12-year observation period, in most all cases, during periods when rates increased by 100 basis points or more, convertibles not only posted positive results but also returned attractive relative results," Miller said.

"Incorporating expected behavior of equity markets, volatility trends and corporate bond performance in a rising interest rate environment leads us to maintain our original 2004 estimates of high-single-digits to low-double-digit returns for convertibles."

Citigroup's baseline forecast for the U.S. economy and interest rates puts the Federal Funds rate at 1% in 2004 and 2.25% in 2005, the 10-year Treasury yielding 3.95% in 2004 and 4.95% in 2005 and real gross domestic product growth at 5% in 2004 and 4.4% in 2005.

Those estimates could change in the event of a structural slump in which U.S. productivity growth slowed dramatically, stagflation - rising inflation, rising interest rates and weak growth - market nirvana as a result of low inflation, low interest rates and strong demand, or traditional overheating.

Over the last 12 years Miller identified five instances where the 10-year Treasury advanced by more than 100 basis points.

In the early 1990s

From mid-October 1993 to mid-November 1994, 10-year Treasury yields shot up 281 basis points.

During this period the S&P 500 was up 1.5% and volatility surged 51.8%, Miller noted.

From Sept. 30, 1993 through Oct. 30, 1994 convertible returns were up 1.2% with their underlying stocks up 4.7%. High-grade bonds were off 3.3%, while junk bonds gained 2.3%.

In other words, with rates on the rise, all asset classes except investment-grade bonds posted positive results.

In the mid 1990s

From January through July 1996, 10-year Treasury yields rose 153 basis points.

During this period, stocks performed quite well advancing 7.8%, Miller noted, and volatility also increased 29.3%. He also noted that high-grade corporates outperformed Treasuries but were still off 3.1%, illustrating a tightening of credit spreads. Junk bonds advanced 2.91%.

From Dec. 31, 1995 through June 30, 1996 convertibles rose 8.1% with their underlying stocks up 10.3%.

The tech bubble

From Oct. 5, 1998 through Jan. 21, 2000 10-year Treasury yields spiked upward by 263 basis points.

"This was an extraordinary time for the convertible market as well as the equity markets. This was the start of the infamous 'bubble' tied to the telecom and technology craze," Miller said.

"Typical correlation analysis does not hold during these times of a meteoric increasing equity markets. Historical relationships become disconnected as a result of asset bubbles of this nature."

Despite the spike in rates, he noted that "the stock market never looked back on its way higher."

In fact, stocks were up 45.8%, while volatility cratered in a decline of 54.1%.

From Sept. 30, 1998 through Dec. 31, 1999 convertible returns shot up 56.1% while their underlying stocks were up 70.8%. Even high-grade (+0.3%) and high-yield (+5.3%) corporates posted positive results during this period. Once again, spreads narrowed during this period.

The bubble bursts

From Nov. 7, 2001 through April 1, 2002 10-year Treasury yields gained 123 basis points.

"In addition to correlation analysis problems associated with markets in an overheated environment, there are also problems with such analysis as those bubbles burst," Miller said.

While rates increased, high-grade corporate bonds dropped 2.4%.

However, thanks to impressive spread compression of some 272 basis points, he noted, junk bonds gained 4.6%. From the equity side of the equation, stocks advanced by 3.3% as volatility continued to drop by another 35.7%.

From Oct. 30, 2001 through March 31, 2002 convertible results rose 3.1% while their underlying stocks improved by 5.0%.

More recently, in 2003

From June 13, 2003 through Aug. 15, 2003 10-year Treasury yields gained 142 basis points.

During this period, equity returns advanced 0.5% while volatility was 11.6% lower.

"At this point in time, the corporate market had realized much of the spread tightening it would undergo, although high-yield spreads did fall an additional 63 bps," Miller said.

Consequently, high-grade bonds lost 4.5% and junk bonds dropped 2.2%.

From May 31, 2003 through July 31, 2003 convertible returns were up a slight 0.9% and the underlying stocks were up 5.7%.

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