Citi projects U.S. convertible outright return of 2%-5% for fourth quarter, more than 10% for 2010

By Rebecca Melvin

New York, Oct. 14 - U.S. convertible market outright returns should be roughly 2% to 5% for the December quarter, which will help put full-year convertible returns near or above 10%, according to Citigroup convertible market commentary.

Citigroup's outlook incorporates an estimate of a 4% increase in the S&P 500 index in the fourth quarter along with projected returns of another 1% to 3% for high yield and a current annual convertible market yield of 4.1%, the Citigroup convertibles team said in its third-quarter review and outlook published this month.

"Along with anticipated out-performance for high yielding issues, we recommend that convert players employ a barbell approach, holding both relatively high delta, equity sensitive names and lesser credit quality, high yielding converts," the Citigroup convertibles team said.

Convertible investors should consider opportunities afforded by refinancings, mergers and acquisitions and other special situations, which are among the best opportunities in the convertible market at the present time, the team said.

"The availability of cheap funding will, we believe, enable a pickup in merger and acquisition activity (as we've seen in the airline industry and more recently in the oil service sector), a trend which could ultimately boost capital market activity and convertible issuance," the team said.

The flow of issuance driven by convertible repurchases has largely subsided as valuations for existing issues have increased. But with interest rates hovering near record lows, a small amount of refinancing activity should help sustain new convertible issuance for the time being.

Mergers and acquisitions would also push convertible prices higher on an absolute basis and increase scrutiny of relevant make-whole provisions, the Citigroup report said.

In addition, more corporate cash equals dividends, and with companies stockpiling cash, dividend initiations and increases have become more frequent among convertible issuers. Scrutiny of relevant dividend protection features should follow.

And cross-over and better junk credits (BBB/BB) outperformed in the most recent quarter since that's where the flight to quality meets the hunt for yield. In the year to date, BB credits have outperformed the other high-yield categories, returning 11.6%. In the third quarter, the return was 6.6%.

Most recently, though, the bottom of the curve has outperformed with the CCC index bringing in 4% in the month of September, compared with 3% for the HY Market index. Presently, risk aversion seems to have taken a back seat to investors' desire for yield and given that, the Citigroup team continues to think that BB and cross-over credits will outperform.

Issuance remains weak

Proceeds of U.S. convertible issuance in the third quarter of more than $9 billion represented the biggest quarterly sum in 2010, but the figure still remains far below issuance totals predating the market crash, according to Citigroup's review.

Low interest rates continue to steer potential issuers into the straight debt markets instead of into convertibles, the review said.

"We don't anticipate a marked pickup in convertible issuance until such time as interest rates move higher," the Citigroup team said.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.