Merrill Lynch analyst: Convertible market cheapest since August 2003, may signal buying

By Ronda Fears

Nashville, March 23 - Merrill Lynch & Co. convertible analysts said in a report Wednesday that cheapening in the convertible market may finally be signaling a time for buyers to step in.

"After a tough six months, we are starting to see buy signals in the U.S. convertible market. The convertible market has cheapened, gamma has increased and volatility looks to be bottoming," said Merrill convertible analyst Marc Malloy in the report.

"For investors that have been sitting on the sidelines, it may be time to start picking up attractively priced converts. This report highlights positive market trends and convertibles with attractive risk/reward profiles."

Specifically, the report identified 128 issues that have favorable risk/reward profiles, versus 67 issues a year ago. Some of those, which the report noted Merrill has a buy rating on the underlying stock, include the Fairmont Hotels 3.75%, Fisher Scientific 3.25%, Freeport-McMoRan 7%, General Mills 0%, Health Management 1.5%, Lamar Advertising 2.875%, Northrop Grumman 7%, Schlumberger 2.125%, Valeant 4% and Walt Disney 2.125% issues.

Market cheapest since 2003

Valuations appear to be more reasonable, Malloy said, pointing out that Merrill's convertible index is currently trading at a 0.63% discount to estimated theoretical value - almost 1% cheaper than a year ago.

Prior to February, the last time the convertible market was cheaper than its current level was more than a year and a half ago when it traded at a 0.93% discount on Aug. 31, 2003, according to the report. Malloy said the current cheapening trend, which began at the close of the first quarter of 2004, came after a 24-month richening trend between March 2002 and March 2004 when the discount to theoretical value went from 4.67% cheap in September 2001 to 0.35% rich in March 2004.

"We believe that convertibles are actually cheaper than this statistic [0.63% discount] would indicate," Malloy said.

"However, at current levels, we believe that much of [the] negative news has been priced into the level of outstanding convertibles. In addition, the supply demand imbalance (we are looking for net negative issuance of about $10-$20 billion) in 2005 should help to support valuations at around the present level, or a little cheaper."

Low vol magnifies cheapness

Considering volatility levels, particularly the call implied volatility versus historical volatility, the convertible market looks even cheaper.

"We believe at present, call implied volatility (which is a forward looking measure) gives a more accurate representation of volatility. By substituting call implied volatility for historical vols, we estimate the U.S. convertible market is actually trading at a 1.62% discount to our estimate theoretical value," Malloy said.

That level of discount is higher than the three-year average of 1.13% cheap and is closer to the five-year historical cheapness of 1.94%, he added.

Volatility may bottom out toward the end of 2005, however, and lend support to an upward trend in convertible prices.

"We see evidence that the current volatility downtrend could reach its trough in late 2005 and the bottom need not be much lower than current levels," Malloy said, adding that a 10% across-the-board increase in volatility would add about 2% to outright convertible returns and 5% to hedged returns.

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