Convertibles market down in August, credit spreads widest since 2003 Lehman Brothers report says

By Evan Weinberger

New York, Sept. 7 - The convertibles market had a tough month in August, underperforming the benchmark equities and fixed income markets by a "fair margin," according to a report released Friday by Lehman Brothers. Credit spreads expanded to their widest point since 2003, the report noted.

According to the report by Lehman Brothers convertibles analysts Brendan Lynch and Venu Krishna, the convertible market fell 21 basis points in August. However, even with the drop, convertibles still outperformed most other investments on an outright basis, with a 4.78% outright return. Lehman Brothers said that the Standard & Poor's 500 gained 1.5% for August and 5.2% for the year to date while the Nasdaq picked up 2.07% for August and 8.06% for the year.

Investment-grade convertibles outperformed non-investment-grade and unrated convertibles in August. Investment-grade convertibles returned 1% for the month, while non-investment-grade and unrated convertibles lost ground for the second month in a row. In July and August, investment-grade convertibles were down 11 basis points compared to a loss of 2.4% for intermediate-grades, an 8.4% downturn for speculative-grade convertibles and a 2.3% loss for unrated issues.

Widening credit spreads in August contributed to the fall in convertibles, according to the report. High yield spreads expanded 29 bps to 442 bps, the highest month-end level since October 2003, the report said. Investment-grade spreads moved out 17 bps to 133 bps, the highest levels since April 2003.

"Spreads are likely to remain elevated pending a reduction in deal/supply backlog and improved visibility in credit," the analysts said.

Implied volatility was also up in August, the analysts noted. Among investment-convertibles with at least one year of call protection, implied volatility gained 0.4% to 26.4%, last month. Investment-grade implied volatility stood at 26% at the end of July. Option surface volatility increased to 27.4% from 27.1% over the course of August.

Equity volatility, the VIX, moved to a 52-week high of 30.8% in mid-August before settling in at 23.4% by the end of the month, a negligible change from the end of July.

"As mentioned last month, we believe implied volatility in the investment-grade convert space may be understated by around 1-2 points given the recent sharp moves in both credit and option surface volatility, and investors' focus on liquidity and price action," the analysts said.

Lehman Brothers said that 46% of convertibles represented in its Convert Composite index lost ground in August. On a sector level, capital goods sector convertibles posted a 2.2% overall gain and noncyclicals picked up 0.8%. Basic industry convertibles were the worst performers for the month, losing 2.4%, followed by transportations, which lost 2.2%.

For the year, though, basic industry has been the best performer, adding 27.7%, and energy sector convertibles have picked up 19.8% on the year, making them the second-best performers.

Among convertibles listed by Lehman Brothers, General Cable Corp.'s 0.875% convertible senior notes due Nov. 15, 2013 lost 22.4% in August against a 26.8% loss in its common stock. For the year, the Highland Heights, Ky.-based maker of electrical and electronic wires and cables' 0.875% convertibles gained 22.7% versus a 33.1% stock gain.

The biggest gainer for the month, according to Lehman Brothers was Sunnyvale, Calif.-based internet equipment provider Juniper Networks Inc.'s zero-coupon convertible senior notes due June 15, 2008. The convertibles picked up 9.6% versus a 9.9% common stock gain. For the year, the convertibles are up 52.6% versus a 73.8% common stock gain.

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