Outlook 2012: Convertibles poised for modest gains after 2011's mostly negative returns

By Rebecca Melvin

New York, Dec. 30 - The average convertibles player didn't make much - if any - money in 2011 amid a rash of issue-specific "blow ups," widening credit spreads, a plunge in the markets in August and persisting risk aversion and lack of new issuance going into the third and fourth quarters.

Despite the potent list of negatives, 2011 wasn't the maelstrom seen in 2008. On the contrary, there was positive balance to the trading side of the market, which was called "pretty resilient."

"Some days were pretty bad, but some were surprisingly good," a New York-based sellsider said.

"Even big orders were able to place within a few days, and within a half point to a point of previous markets," the sellsider said. In contrast, "70 million [dollars of bonds] in '08 would have moved the market 20 points."

In September of 2008, the Lehman Brothers bankruptcy set off a paroxysm of margin calls and liquidations that essentially caused the markets to seize up for the remainder of the year.

Meanwhile, the outlook for convertibles is fairly bright for 2012, market players said. Anxiously awaited redemptions didn't come in as forcefully as feared, and funds have not syphoned money out of the space. Meanwhile, paper is attractively priced right now. But liquidity remains a concern.

Valuation cheapened

The convertible bond market looks about 1.5% cheap in aggregate going into 2012, which is different from the beginning of 2011 when the market was fully valued to marginally rich, according to Barclays Capital Inc.'s U.S. convertibles research team.

During the past year, non-investment-grade convertible bond spreads widened 282 basis points to 838 bps, which was greater than the high-yield market, which widened only 190 bps to 696 bps, Barclays' research team said in its outlook report published Dec. 15.

The spread differential between convertibles and high yield went from plus 50 bps to plus 141 bps, highlighting the cheapening in the asset class.

Similarly, investment-grade convertible bond implied volatility declined by around 4 points to about 29%, while listed surface volatility of the underlying shares expanded to about 34%.

The cheapness lends some appeal to the convertible bond market going forward.

Against a 2012 backdrop of significant macroeconomic uncertainty, convertibles are "well poised to provide risk-controlled equity exposure with decent yield, according to Barclays.

Currently, U.S. convertibles sport an average yield of about 4.9%, Barclays said.

Macro concerns

Macroeconomic concerns are the primary risk to the asset class for 2012, and the most prominent macro concern is the European sovereign debt crisis, market players agreed.

Given that risk, portfolio managers are advised to remain cautious, giving preference to balanced convertibles with shorter durations, focusing on bond structures as opposed to preferred shares or mandatories, while carefully selecting credit exposure via busted yield plays. Weighting exposure to defensive sectors is also recommended, Barclays said.

Balanced convertibles are those in the middle of the spectrum that have a 20% to 70% premium over shares, as opposed to equity sensitive issues that have a premium of under 20%, or busted, or those disassociated with the equity market and more purely credit plays, which have premiums of more than 70%.

Barclays eliminates from its consideration convertibles with pricing that is less than 60 on the dollar.

"We are biased toward higher quality, non-investment-grade securities that offer better risk-adjusted returns than investment grade, Barclays' convertibles research team, Venu Krishna, Manoj Shivdasani, and Piyush Anchliya, wrote in their report.

Negative returns in 2011

By Barclays' measures, U.S. convertibles posted a disappointing negative 4.9% return for 2011 through Dec. 9, but looking ahead, the analysts foresee a mid-range return of 7% for 2012.

The positive outlook is fueled by a set of assumptions, including mid-single digit returns in underlying equities, and coupon income, which has a current yield of 3.7%, and modest spread tightening, the Barclays team wrote in their report, titled, "2012 Outlook: Dusting off from a Stumble."

2012 upside

In framing upside and downside return scenarios, Barclays considered plus 15% or minus 15% equity moves and spread tightening associated with that.

"We estimate potential total returns of plus 12.1% on the upside and minus 5.7% on the downside.

This past year, the Standard & Poor's 500 stock index's modestly positive return wasn't mirrored in the convert universe as is typically the case because the stocks underlying the convert universe did not do as well on a relative basis.

For 2011, the convertibles market "clearly underperformed," Barclays said.

Outright, or fundamental, returns were solidly in negative territory, underperforming equities; while convert arb struggled with varied returns that were likely driven by specific sub-strategies.

Hedged convertible strategy returns for the year came in anywhere from minus 8% or minus 9% to plus 7% or plus 8%, "with most of them coming in right around the flat line," a New York-based sellsider said.

Barclays pointed out the negative return followed extremely positive performance in 2010 and 2009. In 2010, convertibles returned plus 18.1%, and in 2009 convertibles returned a whopping plus 50.7%.

2011 started positive

After being positive for the first four months of 2011, many convertibles players began to hemorrhage gains in May and June and into midyear.

S&P's ratings downgrade of U.S. debt to AA+ from AAA in August took things another leg lower and left many traders unsure of what to do next. In general, shorter-dated and better-quality credits held up pretty well while longer-dated and weaker credits gapped lower.

The equities sell-off at that point was so strong that even positive earnings that beat estimates precipitated sell-offs. This happened to Quicksilver Resources Inc.

Shares of the Fort Worth, Texas-based oil and natural gas producer tanked Aug. 8 despite great earnings. But the Quicksilver convertibles held up on a delta basis and were mentioned as one of the convertible market's winners for the year.

In an effort to combat the macro forces assailing markets, some convertibles traders essentially stopped trading beginning in the third quarter to avoid further pitfalls, a New York-based sellsider said.

The S&P downgrade, which specifically affected U.S. sovereign debt, also sparked a sudden buying spree in U.S. Treasuries.

One trader said he wasn't surprised to see the buying in Treasuries because it is one of the few areas of the global debt markets that "allows enough for buying; and it's about liquidity," he said.

The Treasuries rally helped convertibles slightly, but the lift was muted due to the short dated composition of the convertibles market.

Resilient trading

Despite overall uncertainty, the convertible secondary market held in pretty well and was pretty healthy with decent flows, market players said.

One New York-based sellsider described a "see-saw" dynamic, in which the hedged funds got cleaned out of inventory and the outrights held a lot of paper, but then the sovereign debt crisis hit, and the outrights started to sell and the hedged players bought.

First, the outright buyers were pushing the market and then the hedged players would step in, he said.

At one point, even the European outright investors provided balance to the market and were coming in, hitting those bids, the sellsider said.

The market stabilized in the last two months of the year, with participation from outrights in the United States and Europe, the sellsider said.

"Within a half point bid, offer, we were cleaning up the inventory," he said, to support the idea that there was balance to the trading side of the market.

It "got out of balance" and liquidity got scarce in May and June, and then July and August things started coming for sale. There was some reviving issuance in October - although not anywhere near what the market needs - and the dynamics were pretty healthy," the sellsider said.

At the end of the year, investors had cash on hand, likely owing to difficult investing environment. And given that environment, market players may be able to justify having larger amounts of cash than they would ordinarily be allowed to have.

"In my daily conversations, there are people with cash and redemptions weren't as bad as everyone was expecting. The product has value relative to other parts of the asset spectrum," the sellsider said.

Liquidity remains a concern

While convertible paper is cheaper than last year at this time, it's "not ridiculously cheap," a New York-based sellside analyst said. And even with valuations at more reasonable levels, market players will remain cautious about putting money to work given the macroeconomic picture.

"There could be a day you come in next week and a European bank has failed," the analyst said, and then there may be redemptions. "They are still sitting on their hands."

In addition, there are pretty widely divergent views out there about what people think is going to happen to the U.S. economy in 2012, and that will continue to put a damper on taking risk and putting money to work, he said.

The analyst predicted that investor behavior isn't going to change simply because the calendar page turns to a new year.

On the other hand, some market players believe that January will bring a bustle of activity as investors look to put on positions geared to new returns for 2012.

"All the stuff in Europe will probably continue, but the big difference is that once you're past the end of the year, people have to figure out how to make a return. They will be starting with a clean slate again," a second sellider said.

Also supporting his premise, "personality wise, those guys go crazy if they can't trade," he said of fund managers.

Nevertheless there's no getting beyond Europe, he said. So many financial instruments are tied to the global cost of funds. So for those that rely on leverage or borrowed money for their investment strategies, if the cost increases and they don't pay for themselves anymore, they get unwound.

"If the European situation gets worse, it becomes contagious and prime brokers start charging hedge funds more to give them credit, and it gets to be an ugly situation as a lot of stuff starts to get unwound," a New York-based trader said.

"If it gets bad enough, they literally push funds off the platform. Then they get 60 days to liquidate; so there's that cloud still hanging over everyone's head," he said.

In addition, new issuance still isn't keeping pace with maturities, calls and puts, and that's a tail wind for the market, an analyst said.

"The natural supply-demand dynamic is in your favor, but with the European debt crisis, we're more or less in a holding pattern," the analyst said.

As for recently favorable U.S. economic data and the possibility of the U.S. economy being able to build in 2012, he cautioned and said with "almost every other economy in the world, including China, Europe and Japan, under pressure," it was unlikely that the U.S. could withstand that and operate in isolation of all those events.

Blow ups

Convertible players said this past year's market casualties were understandable considering the challenging investing environment.

"In light of the euro zone sovereign debt crisis, it's not all that surprising that we've seen some of these blow ups," a New York-based sellsider said, referring to company-specific news and credit events that caused sudden swings in shares that went against convertibles players as well as longer, slower downturns.

"Idiosyncratic risk associated with underlying equities impacted returns," Barclays said. For example, big convertible names including General Motors Co., Cemex SAB de CV, Citigroup Inc., and the solar sector, saw significant declines in their shares for the year. The solar sector convertibles had one bankruptcy and more than a few names with stock plunges of 60%, 70% or more than 80%.

"Look at GM stock. It was down significantly from the highs of $36 to $19; it's a $5 billion mandatory issue, with very high delta, and that contributed to the performance of convertibles," a New York-based analyst said.

Cemex was another problem for the market with $2.3 billion in convertibles. Its stock is down about 50% for the year, and it hurt on both sides of the investment community, both hedged and outright players. Its shortest dated convertible was trading at 58 at the end of the year.

Meanwhile, underperformance of the materials and financials sectors, which accounted for about 18% of the convertibles market, contributed to weakness, as did the higher beta tilt of the stocks comprising the convertibles universe.

The Jefferies Group Inc. bonds decimated outright investors after the European sovereign debt crisis and bankruptcy of MF Global Holdings Inc. spooked market players about the mid-sized investment bank's prospects. Those bonds were trading in the low 80s, and they had been higher at 108-109.

The Dendreon Corp. convertibles were also a disaster if owned on an outright basis. In the past year, Dendreon shares collapsed to a low of $6.46 from a 52-week high of $43.96, and the Dendreon 2.875% convertibles due 2016 are currently trading around 70 after reaching heights of 115 to 117 prior to the summer meltdown.

NuVasive Inc. was another blow up for outright investors.

Several notable bankruptcies put the convertible market under severe pressure too.

Even one bankruptcy is enough to put a small shop out of business, a Connecticut-based trader noted; but 2011 brought several large bankruptcies.

They included Evergreen Solar Inc., which filed for Chapter 11 bankruptcy in August after missing a coupon payment on its 4% convertibles in July; MF Global, which filed for bankruptcy protection at the end of October after concern about its European debt exposure resulted in ratings downgrades and margin calls; and AMR Corp., the parent of American Airlines, filed for protection from creditors at the end of November, causing the large AMR convertible bond issue to plunge about 35 points to around 15.5.

Research leads to scrutiny

There were also the research-inspired blow ups of China-related companies. Sino-Forest Corp.'s two convertible bond issues plunged outright, but actually expanded on a hedged basis, after a meltdown of the Toronto-listed Chinese commercial forest plantation operator's shares on allegations of fraud by Muddy Waters Research.

Sino-Forest's 4.25% convertibles due 2016 fell on the initial news to 30 after being wrapped around 116.

More recently in-vitro diagnostic company China Medical Technologies Inc. gyrated on Glaucus Research Group's report alleging fraud and embezzlement.

"Beyond picking the right names, a lot of it usually comes down to avoiding the right names," a New York-based sellsider said.

"I would bet that the more conservative guys out there did better. It probably comes down to not going out too far out on the risk spectrum, and not going out too far in terms of duration."

Others concurred that avoiding certain names was the best way to do well in 2011.

The convertibles market has proved that it's not a place for the faint of heart. Indeed, it requires a pretty hearty soul to bear up under low liquidity, low issuance, often questionable credits, and the macroeconomic scene that have kept equities whipsawing, one New York-based trader said.

"It's difficult; it really is. You've got to go from name to name to name. There are a lot of catalysts. You've got the same relative valuation one day and a month from now you may be looking at it and the whole tape stinks. Maybe you want to buy the bond because you want to short the stock. You have to find it and when it pops around, you have to be ready for it and you have to be looking for it....and it doesn't trade every day," said New York-based Mark Henriquez of Odeon Capital Group LLC.

"This was just a difficult, lackluster year, tough for a lot of asset classes because of all the macro stuff," another trader said.

Trades that worked well

On the other hand, some of the year's disasters made money for certain players who rode the paper back up from their low marks. The AMR convertibles recouped as much as 10 points from their lows, and Clearwire Corp. was another name that distressed traders could make money on after its initial drop.

Central European Distribution Corp. was also a name that didn't start out as a very good scenario.

"But we've done well on that, capitalizing on the dip and going back up," a Connecticut-based trader said.

Even so, there weren't really a lot of standouts in terms of trades that worked well in 2011, market players agreed.

"I don't see a ton to be honest," the Connecticut trader said.

Even M&A wasn't particularly notable, sources said, although the Massey Energy Corp. bonds did well on the link up with fellow coal producer Alpha Natural Resources Inc.

The Massey convertibles traded up about 10 points to 110.25, which was higher than the 108 make-whole takeover protection valuation.

NovaMed Inc. was also mentioned as a winner. The $75 million convertible issue gained about 4 points outright and was also higher on a hedged basis after word that the Chicago-based ambulatory surgery center agreed to be acquired by H.I.G. Capital, a private equity firm, for about $109 million.

High-yield, rather than income-oriented, players did better. But even a lot of the event-driven situations in the biotechnology space were negative this past year.

For hedged players Dendreon did well depending on the hedge when the underlying shares plunged to $7 from $35 in July.

"Depending on the hedge, the arb community made money on those Dendreons," the Connecticut trader said.

Several light delta names did well including Superior Energy Services Inc. and Quicksilver going into August. They worked out really well on swap, with money made by being short the stock, a New York trader said.

Healthy technicals

The profile of the convertible market is healthy right now at 36% equity sensitive, 40% balanced, or typical, and 22% busted. The composition of the buyer base also remains healthy with a balanced mix of arbitrage at 52% of the market and fundamental, or outright, investors accounting for 48% of the whole, according to Barclays.

Looking ahead, the convertible market is shaping up to be a somewhat lopsided universe in terms of duration. There is longer-dated paper coming due in 2016 and beyond, while a lot of the shorter-duration paper was repurchased by issuers in 2008 and part of 2009, Henriquez said. "Some of the shorter-duration paper will trade at a premium, and we're starting to run out of $1 billion issues."

But the large, $1 billion-plus issues were an anomaly for the market, Henriquez said.

"That was a re-sculpting of the convert market anyway," he said, referring to companies that were tapping the market for the purposes of improving financials rather than from a genuine capital need.

Those issues have ended up being niche, cash substitutions for the most part anyway, he said.

"Some of the 'old school' guys are used to doing a plain vanilla convert arb strategy; but that leaves you underperforming those that take more risk and get more directional," a New York-based sellsider said.

When hedging a name on a delta-neutral basis, one is not betting on the stock, volatility or credit, but setting it up so that one can clip cash flow. This player is invested in convertibles that will break even in less time than the bond is going to be called or mature.

"People have to create new ways of setting things up. If you like the stock, maybe hedge it lightly. But with the constant risk-on, risk-off stuff, people never get a sense of which way things are going," the sellsider said.

In 2011, low premium names, or the equity sensitive names, set up on heavy deltas worked well.

"Anything with a price tag of 140 to 160, with a 5% to 10% premium and set up on an 80% to 95% delta did well," one trader said.

Another possibility was deeply out-of-the-money put trades. Then if the market corrects substantially, the premium widens out 4 or 5 points, and on a heavy delta, your position will be taking the benefit of the stock correct, he said.

Overall though, there hasn't been a lot of "rhyme or reason to the way things moved, so it's hard to blame the PMs. It was a frustrating year, with too much work for not enough money," the trader said.

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