Pitfalls ahead, but convertibles expected to perform well in 2008, Lehman report says

By Evan Weinberger

New York, Jan. 7 - Coming off a year where the convertibles market outperformed the Standard & Poor's 500 while coming up short of the Nasdaq, Lehman Brothers convertibles analysts expect a small increase in convertibles returns for 2008, according to a report released Monday.

But given the uncertainty enveloping financial markets following the subprime mortgage meltdown, the analysts Venu Krishna, Brendan Lynch and Manoj Shivdasani say that the convertibles market faces "challenging headwinds."

Convertibles returned 5.62% in 2007, versus the 5.49% rise in the S&P 500 and 10.7% for the Nasdaq. The analysts say they expect convertibles to rise 5.7% in 2008. That's only their base assumption.

Uncertainty reigns, however, heading into 2008. Lehman Brothers economists put the likelihood of a recession at 35%. Even if there is no recession, the economists expect a wider economic slowdown. From the third quarter of 2006 through the third quarter of 2007, GDP rose 2.5%. Lehman's economists expect GDP to grow by 1.8% in 2008, with continued to sluggishness in 2009.

Lehman's estimates for convertibles growth range from a best-case 11.1% to a worst-case loss of 4.27%. That is in line with their forecast of somewhere between a best-case 19% gain and a worst-case loss of 11% for equity markets.

Krishna, Lynch and Shivdasani expect volatility to stay up and credit spreads to widen out farther. In 2006 and 2007, the analysts say, the VIX floor was at around 10. They expect the 2008 VIX floor to move up to around 15. With the Fed likely to respond to continuing bad economic news and lower-than-feared inflation with further rate cuts, the analysts expect serious peaks and troughs in volatility. "This should make any spikes above the 30 level on the VIX unlikely to persist for a significant period of time, even in the event of a recession," they wrote.

Credit spreads moved out to several-year highs during the past year, the analysts said. The average credit spread for investment-grade convertibles closed 2007 at 176 basis points and for noninvestment grade at 527 bps. They closed at 70 bps for investment grade convertibles and 354 bps for noninvestment grade convertibles in 2006.

"Credit spreads appear poised to widen further from current levels, and are expected to have a bigger impact on market valuations than in recent years," the analysts said.

New issuance surged in 2007, with $95.3 billion raised in 180 new deals. The Lehman analysts expect a similar haul in the coming year because of companies' needs "for restructuring and growth capital against a challenging macro economic and capital constrained backdrop."

The analysts expect many of the new issues to come in cheap and with relatively short three to seven year maturities. In 2007 mandatories and preferred stock convertibles were popular as credit conditions tightened. Expect the same in the year to come, the analysts said.

Those structures performed well for investors, with mandatories returning 12% and preferreds 6.7%.

However, the analysts recommend that investors stay away from equity-sensitive issues such as mandatories and preferreds. Instead, investors should stick to traditionally structured convertibles that provide more downside protection.

The key word for 2008, Lehman said, is quality. The analysts suggest investors go overweight on large and mid cap convertibles and try to have a bias toward investment and intermediate grade credits.

Sector-wise, the analysts say go overweight non noncyclicals, telecom and energy convertibles. Be wary of cyclical industries, given the uncomfortably high chance of recession, and the financial sector in general. Real estate investment trusts are another sector raising red flags for the analysts.

Some of the convertibles that Lehman Brothers likes are Peabody Energy Corp.'s 4.75% convertible junior subordinated debentures due 2066, Molson Coors Brewing Co.'s 2.5% convertible senior notes due 2013 and Intel Corp.'s 2.95% junior subordinated convertible notes due 2035.

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