U.S. convertibles expected to return 11.9% for 2009 using base case: Barclays Capital analysts

By Rebecca Melvin

New York, Jan. 6 - Total market return for U.S. convertibles should be 11.9% for 2009, assuming no change in equities, 20% tightening of investment-grade spreads and 10% tightening for non-investment-grade spreads, according to Barclays Capital analysts.

The base case scenario also assumes a 1% default rate for investment-grade debt and an 8% default rate for non-investment-grade debt, according to the Barclays U.S. convertibles research highlighted Tuesday during a conference call.

Using an upside set of assumptions, total return for U.S. convertibles was seen at 23.6% for 2009, with the downside case of 2.3% return for 2009, Barclays analysts Venu Krishna, Manoj Shivdasani and William Gioielli predicted.

The forecast compares to a loss of 34.6% for the Barclays US Convertible Index in 2008, after the year-end rally - a result that outperformed equities, but underperformed credit, the analysts noted.

Convertible arbitrage strategies underperformed other hedged strategies, losing 58.15% in 2008, compared to relative-value arbitrage, which lost 37.56%; distressed securities, which lost 27.62%; and equity hedge, which lost 25.72%, the analysts said.

Two hedged strategies ended 2008 in the black, including macro and merger arbitrage, which returned 6.17% and 3.36%, respectively.

Defensive stance

The analysts recommend being overweight consumer staples and health care and underweight financials. Their portfolio is overweight consumer staples, at 9.1%, versus the overall market's 2.9%; and health care, at 24.2%, versus the market's 21.6%, to maintain defensive exposure. It is also underweight financials at 12.1%, versus the market's 25.7%. The financials include two real estate investment trusts and Nasdaq.

Barclays also recommends being overweight bond structures, at 94%, versus the market's 81%, and overweight investment-grade and intermediate-grade credits, with investment grade at 49%, versus the market's 38%, and intermediate grade at 36%, versus the market's 25%.

Credit will most likely be the key driver of the convertibles market in 2009, while equity volatility is likely to remain elevated, the analysts said.

Credit spreads are wide and are pricing in a fair degree of pessimism - which means better relative value in credit than equities.

"We recommend investors focus on more defensive investment-grade and large-cap, short-dated convertibles. High-yield converts appear attractive too, but come with greater risk," the Barclays analysts said.

"We recommend some delta exposure but suggest that investors stick to balanced, not equity-sensitive converts," they said.

Investing in short effective maturities is still the way to go, they said, and 91% of their portfolio has a put/maturity of 2.8 years.

They discouraged stretching for yield by avoiding deeply distressed names, and they are 52% large cap and 27% mid cap, as opposed to the market's 39% and 18%, respectively.

Their recommended portfolio contains only 33 names as opposed to the overall U.S. convertible index's 728 names.

The current yield of their own portfolio is 3.6%, compared to 5.9% for the overall index; premium is higher at 70% compared to 66.7%; and coupon, yield to put and yield to maturity is lower at 8.8% compared to 13.6%.

Names on the recommended list include Arris Group Inc., Computer Associates, Carnival Corp. and NII Holdings Inc.

Economic outlook

The U.S. and global economy is in an uncertain state, and macro data is weakening at an accelerating rate while capital markets remain frozen, the Barclays analysts said.

Expect a "deep recession" along with aggressive action from policy makers that includes Fed rates remaining at or near zero well into 2010, they said.

They also said expect to see continued capital market intervention, with the government buying or guaranteeing hundreds of billions of dollars of assets, as well as a major fiscal stimulus package.

Sectors affected by the downturn first are likely to recover first: autos and home construction are likely near their bottoms for this cycle. Capital spending, particularly on structures, is likely to slide into a deep recession even as the overall economy starts to turn upward.

Also expect a sharp reversal in inflation, which is a positive. The analysts are calling for a second-half recovery, with GDP predicted to contract 4.5% for the 2008 fourth quarter and 2009 first quarter, and a negative 1% reading for the second quarter, but then turning positive to 2% in the third quarter. Unemployment will spike to 8.2% in the third quarter, they predicted.

S&P 500 earnings are expected to drop in 2009, with an earnings-per-share bottom seen in the third quarter and recovery by year-end.

Krishna also said he expects the ratio of fallen angels to rising stars to be 8:1, with the high-yield issuance of 2005, 2006, 2007 putting issuers in good stead for now, but when they want to raise funds they will start looking at the convertible market.

About $31 billion in value was destroyed through financials as markets turned south, and they will be the last to come back, Krishna said. Also General Motors Corp. and Ford Motor Co. convertibles lost $11 billion of value in 2008.

From May 15 to Nov. 14, 2008, our delta neutral analysis estimates that the market has leaked $18.6 billion in value, Krishna said.

Downside participation was 84% from May 15 to Sept. 30, and 64% from Sept. 30 to Nov. 14.

Primary market prospects

As for the reopening of the primary market, Krishna said that the market should be able to handily absorb $37 billion to $38 billion of new issuance given the money that has come out of the market and presumably could be reinvested back in.

"With spreads wide, vol high and equity valuations relatively low, it will be a competitive source of funding, and IG will come back first," Krishna said.

"There is a pipeline subject to stability in the broader credit market and the broader capital markets," Krishna said.

New issuance will be relatively cheap. "The market was 3.5% cheap last year through September, and we should expect that level of cheapness this year when the market reopens. There will be mostly bond structures," he said.

As for what percentage of the market remains in convert arb hands, Krishna estimated that it's now about 45% to 50%, compared to 70% previously.

A look at the profile

A look at bonds within the convert market shows that more than 64% by market value has effective maturity of four years or under. Most are in the 70 to 80 price range, followed by 90 to 100, and 50 to 60. A profile of the current convertible market showed that nearly 80% are cash pay bonds, followed by preferreds, followed by mandatories and zero coupon, OID. That profile was little changed from 2007 except that 2008 had more preferreds.

Busted convertibles account for the largest portion of the market, followed by typical, distressed and equity-sensitive issues.

By credit profile, 40% are investment grade, about 35% are non-investment grade and about 25% are not rated.

Market size

Currently there is $192.6 billion of convertibles market value outstanding while the delta stock exposure is $60.7 billion, or 31.5% of face. This means for every 1% change in the underlying stocks, the convertibles market should move by around 0.315%, the analysts said.

The weighted average percentage vegas for the equity sensitive, typical, busted, and distressed segments of the convertibles market are 0.24%, 0.31%, 0.07% and 0.17%, respectively. On an aggregate basis the percent vega is 0.21% suggesting an expected 0.21% change in the convert market's value for every 1 volatility point change.

The weighted average percentage Rho for the universe is minus 2.26%; (i.e. should the credit widen by 100 basis points, the market value of convert universe is likely to decline by 2.26%). The percentage Rho for the IG segment is minus 2.34%.

The convertible market delta stock exposure is dominated by small cap issuers in terms of sheer number of issues, with 562 issues falling into that category, compared with 96 large cap issues and 70 mid cap issues.

But by market value, large cap and small cap are close, with $75.05 billion for large cap, or 39% of the market, and $83.77 billion in small cap, or 43.5% of the market value. Mid cap has just $33.77 billion, or 17.5%, market value.

Financials account for the biggest portion of the convertible universe, with 25% of market value breakdown, followed closely by health care with 22%, and then information technology with 16%.

But using a delta stock exposure breakdown, financials account for less, with 18%, while health care accounts for more with 28%, and information technology accounts for 14%.

Mentioned in this article:

Arris Group Inc. Nasdaq: ARRS

Carnival Corp. NYSE: CCL

Ford Motor Co. NYSE: F

General Motors Corp. NYSE: GM

NII Holdings Inc. Nasdaq: NIHD

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