Citigroup lowers 2004 convertible return estimate to flat from 10% area due to higher interest rate climate

By Ronda Fears

Nashville, May 18 - Citigroup convertible analyst Adrian Miller now sees 2004 convertible outright returns at the flat line versus a previous expectation for returns in the neighborhood of 10%. The revised forecast is a result of a higher interest rate forecast, wider credit spread assumptions, and a slower small- to mid-cap stock price growth assumption.

Under the current rising-rate scenario convertible arbitrage strategy returns also may be dampened in 2004, he said, although some of this could be mitigated by high convertible yields and other factors. He added that a limited scope of alternative investments should keep money from flowing out of the convertible asset class.

"While we believe the fundamental landscape appears sound, with corporate earnings growth and GDP [gross domestic product] estimated to post '04 results of 13.5% and 5.0%, respectively, we believe rising interest rates and general market uncertainty will result in muted market returns," Miller said in a special report Tuesday.

"If April is any indication, the prospect of rising rates has not only stymied the equity and fixed-income markets, it has also negatively impacted the convertible market. We are first seeing it in the muted new issue calendar and then at the secondary trading level which has potentially exacerbated the negative impact on falling convertible prices."

Despite the recent backlash in the financial markets centered on the Fed's recent monetary statement, he said the prospect of an increase in the absolute level of interest rates is not the most important aspect of the upcoming tightening cycle.

"At the end of the day it is the rate of change of the rates which actually impacts the market. Since markets are a pricing mechanism which incorporate rate of change in addition to target levels, a change of the rate of change requires a repricing of the markets," Miller said.

"It is this repricing action which has roiled the markets as of late.

"We believe as long as corporate profit growth remains robust, which is supported by strong GDP growth, the financial markets should shake off their current interest rate hike malaise and refocus on fundamental economic drivers. However the timing of this switch back to sanity will be very difficult to gauge."

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