Lehman analysts: 2005 convertible returns in 7% area, issuance $47-54 billion

By Ronda Fears

Nashville, Jan. 7 - Lehman Brothers Inc. convertible analysts are looking for convertible outright returns of 7% in 2005. As for issuance, they expect new deals totaling $47 billion to $54 billion, flat to 2004 or a gain of as much as 15%.

"Our return estimate incorporates expectations of positive equity market returns, a pickup in interest rates, a modest pickup in volatility, and relatively stable credit conditions in the context of the market's profile and capitalization distribution," analysts Venu Krishna, Brendan Lynch and Manoj Shivdasani said in their 2005 outlook.

"While the impact of new issuance is not captured in our modest returns expectations in 2005, we believe they will likely present opportunities for incremental returns. For 2005, we expect issuance to be flat to up 15% higher relative to 2004 new issuance levels giving us a range of $47 billion to $54 billion."

M&A again vital to issuance

Factors driving the issuance projection include expectations of decent economic growth, improving equity markets, higher interest rates, a modest pickup in volatility, and increased merger and acquisition activity in 2005.

"M&A activity in particular could not only lead to convertible issuance to fund such activities, but could also lead to the use of convertibles as merger currency given the pickup in equity markets in the past two years," the analysts said in the report.

Challenges continue for 2005

Despite a challenging year on numerous fronts, convertible outright returns in 2004 were good at 9.61%. Convertible arbitrage investors faced a far more challenging set of circumstances driven by both macro and convertible market specific factors that caused their returns to significantly underperform their outright peers' returns.

"Though we believe convert market specific risks are likely to ease in 2005, they are likely to be outweighed by macro risks such as the pace of Fed action, the potential for a 'dollar crisis' and rich credit valuations," the analysts said.

The impact from rising rates should be neutral to marginally negative, the analysts said, but the profile distribution of the convertible market also suggests that the performance of equity markets is going to be the key valuation driver for 2005 returns. In particular, they noted that 43% of the convert market is highly equity sensitive.

Moving down credit scale

Extending trends seen particularly in the last half of 2004, the Lehman convertible analysts expect new issues to continue coming from smaller issuers in the more risky credit territory. Thus, portfolios will reflect this with potential for higher returns.

"The proliferation of small cap issuers and of small deal sizes is likely to force investors to move down the credit curve and have a greater number of these issues in their portfolios," the analysts said.

"Given the OAS levels of non-investment-grade convertible bonds, our view of a relatively stable credit environment, and higher earnings growth expectations from this group, we believe investors are likely to find better values in small cap converts."

The Lehman analysts suggest, in general, an overweight position in small caps made up of typical profile converts, non-investment-grade bonds in the basic industry and capital goods sectors with a higher delta exposure than the market.

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