Outlook 2005: European convertible market expected to contract, but seen improving

By Ronda Fears

Nashville, Dec. 31 - There have been numerous recent reports about the meager level of convertible issuance in Europe - currently at a seven-year low by some accounts - driving some investors out of the asset class altogether. But many take heart from the fact that issuance in Europe spiked in late 2004.

"I am reminded of Mark Twain's proclamation 'Rumors of my demise have been greatly exaggerated'," said a top convertible analyst at one of the leading sellside shops in London.

"Yes, some CB funds/desks have lost money and scaled back (forced or otherwise), but convertibles are the greatest product on earth, and greats always bounce back! Whilst I don't see convertibles as 2005's panacea, I don't see it as a purgatory for arb funds/proprietary desks either."

Dollar a drag

Along with low volatility worldwide, the declining dollar in 2004 was a significant hurdle for global convertible investors.

Hart Woodson, manager of the Gabelli Global Convertible Fund, said it wasn't as bad as many perceived, however. He noted that muted returns also contributed to low issuance volume.

"The global convertible market, as measured by Merrill's BBB rated [global convertible] index, is up 6.74% year to date in U.S. dollar terms. About 40% of the index is denominated in currencies outside the U.S. dollar, primarily euros (33%) and yen (14%)," Woodson said.

"Despite the weakening of the U.S. dollar, which all else being equal gave the index about a +2.28% boost, the [global convertible index] was not helped by falling volatility - the VDAX in Germany from 20.79% to 14.36% and the Nikkei 100-day volatility from 26% to 15.8% - and the generally lacklustre returns from Japan."

"Geographically, the weak dollar and the general economic slowdown will be important themes. The weak dollar will benefit U.S. exporters, whose exposure we are increasing while hindering European and Japanese exporters. Our exposure in Europe (26%) and Japan (23%) is focused on domestic companies and avoids companies with significant U.S. dollar exposure."

Woodson expect new issue activity to remain quiet again in the coming year until the economic outlook becomes more certain - but that may be beyond 2005.

Japan may, however, be the exception, he added, "as the domestic economy continues to recover and new rules favouring domestic convertible issuance take effect."

Issuance to improve, not surge

Moody's Investors Service senior economist Guillaume Menuet said in a recent report that despite emphasizing the risks stemming from an appreciating euro, the positive correlation between U.S. and European equity markets has contributed to a general "accommodative" atmosphere for debt issuance in general.

"We estimate that going forward the annual growth rate of debt securities issued [in Europe] might pick up slightly during 2005, given the expected persistence of reasonably healthy outlook for corporate credits," Menuet said in the report. "However, we would be surprised by a double-digit growth in issuance of debt securities, given the cautious approach with respect to capex plans and M&A strategies, at a time when bank loans remain very competitively priced."

Taking a more sober view of the issuance prospects for 2005, the sellside convertible analyst acknowledged that the impact on the competitive landscape and drivers of recovery in the months ahead are not the best indicators for a surge in new convertibles but he is optimistic of an improvement.

"Will things pick up? We think so. Issuance has been hit by forces ranging from deleveraging to declining vol - which of course is related - to proposed accounting changes on both sides of the pond," he said.

The analyst expects European corporates will need funds for acquisitions and to refinance debt, although the catalyst for refinancings may not materialize significantly until 2006.

Squeeze could be beneficial

That some players have retrenched from convertibles may not be a bad thing, anyway, the London sellside analyst said.

"The fervor of 2003 led to too much capital chasing too few opportunities in 2004," he said. "Now we have a more balanced and risk-aware market, which should benefit the higher-quality funds, sell-side firms and issuers, once things pick up."

Indeed, in spite of low new issuance, or perhaps because of it, many see the situation in Europe as an opportunity to build positions rather than liquidate.

"I think it is an opportunity to get some talent and try to build infrastructure," said a U.S.-based hedge fund manager, who said he has been increasingly looking at global convertible opportunities.

"Thankfully, we have very low overhead, a good outright business and we are used to operating in a low fee environment. We are thinking of expanding in Europe. Also note that places like Bank Julius Baer are making efforts to expand hedge stuff [and] probably could absorb a few convert hedgies."

Steve Howell, chief investment officer for Basis Capital based in Sydney, Australia, acknowledges that the convert arb strategy will again likely underperform other strategies in 2005 but he's not ready to abandon ship.

Volatility lower all over

After all, what make convertibles so appealing are the various hedging instruments that boosts returns. And many global convertible funds are not doing so badly, although - as in the United States - low volatility is a particularly sore spot.

The German VDAX - a widely followed volatility barometer - is currently at an eight-year low, having recently stuck a new trough of 14%. By contrast, the VDAX hit a peak of 60% in 2002.

"When all is considered, our view is that CB Arb will likely under perform as compared to other strategies in the year ahead," Howell said. "As a multi-strategy alternative fixed-income manager, the Basis Pac-Rim Opportunity Fund has been rotating out of vega risk - and into more concentrated credit related long/short strategies. We see better alpha opportunities in the long/short credit space, particularly with the advent of the CDX, ITRAXX, Sub-index and tranched indexes."

The Basis Pac-Rim Opportunity Fund was up 4.5% for 2004 through the end of November, he pointed out, whereas the Basis Yield Alpha Fund was up11.5% for the year. Basis manages $260 million.

"Our less than enthusiastic view on vol strategies is premised on positive default expectations for the next six-months or so and strong corporate balance sheets," Howell said. "This, coupled with an ongoing CDO [collateralized debt obligations] bid for credit, is likely to keep credit and equity volatility at lower levels. On top of this we have a neutral to positive view on equities, supported by a less hawkish Federal Reserve."

Creativity a must in portfolios

The U.S.-based manager said the only volatility play is in currencies and to survive in the global convertible market managers have to get creative.

"At this point I believe it is a game of stock/credit picking. The problem with shorting at this low vol stage is that the flood lifts all boats, right?! Okay, it saves you in the end, but I worry by that time you will have to close your fund," he said.

"Looking at the indexes for hedge funds overall, absolute performance is low. Therefore, I believe most hedge strategies share vega risk. Want vol? Buy dollars versus yen, CHF and euros, and buy bond futures or go to CMAs - just think here you are late to the party.

"My numbers are in line but on an absolute basis a 4.35% handle on the 10-year [Treasury] with no fee looks compelling! We closed one small onshore fund but have added more to a new offshore fund. We are adding a little more into the end of the year and then plan to do a little more marketing - but interest is very low.

"The modus operandi is to pick stocks and credits that are cheap relative to the universe and then if the model sees them as cheap we throw it in the arb account."

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