Midyear Update: Some see 2004 convertible outright returns lagging earlier expectations of 10% area

By Ronda Fears

Nashville, July 1 - Convertible returns in 2004, as anticipated at the beginning of the year, are trailing 2003's whoppers, but a mid-year checkup with the market pros shows that some think it's going to be worse than feared six months ago. The asset class is not seen going into a tailspin by any means but rather is suspended by the prevailing uncertainty in the broader markets.

Convertible returns, on an outright basis, are seen coming in flat now versus a previous expectation of around 10% by Citigroup analysts. Merrill Lynch analysts still see outright returns hitting their target of 6% to 9%, even if at the low end, but if stocks turn decidedly south, then returns could be off as much as 4%.

For hedge funds, with a vast array of alternative strategies to boost their overall performance, market onlookers think it is now looking like they will make a showing at the low end of forecasts for 4% to 8%.

Buyside market sources report no change to their expectations, but several noted they were not overly optimistic about 2004 given the monstrous returns in 2003 of 20% and upwards.

"We have no major revisions," said Ted Southworth, portfolio manager at Northern Trust Co., adding he sees little chance of returns going back to levels seen in the late 1990s.

The hedge fund community is more upset with returns thus far in 2004, especially as summer sets in, but they, too, were not expecting to do as well as they did in 2003. As a result, however, the search for new alternative strategies is omnipresent.

"I think most convert arbs were pleased that last years returns were as high as they were, and while disappointed about this year, I don't believe most arbs had very high expectations given how low rates are, how low vol is, and how fully valued the market has been," said the portfolio manager for a new multi-strategy hedge fund seeded by one of the big international banks.

"Investors, however, see historical returns in convert arb and come to expect those kinds of numbers year in and year out. Arbs hope for those numbers but tend to be a level-headed bunch. As for expectations, [they] haven't really changed much. It's a very competitive, efficient market.

Broad markets weigh converts

Stubborn stock prices in addition to a rising interest rate environment, as well as inflationary factors, are the main culprits affecting both outright and hedged convertible players' performance.

Stocks gave a false start to 2004, out of the gate extending the astronomical gains of the late 2003, but they reversed course in the latter part of first quarter and withdrew all or most of those gains.

Now, even as Prospect News goes to press, interest rates are on the rise. While that can boost returns, either by bumping up yields on new issues or by creating bargains with corresponding spread widening, it also increases borrowing costs for hedged players.

Obstinate volatility levels, which are remaining at record low levels, are another key restraint to convertibles' performance.

Outright returns treading water

Following the exorbitant outright returns in the area of 20% to 25% in 2003, this year is more like returning to the 5% to 10% neighborhood seen in 2002, or worse.

Citigroup's convertible analysts now see outright returns flat, or 0%, compared to a forecast in the 10% neighborhood at the outset of 2004.

"We're looking for converts to return about 0% for the full year given our expectations for stocks and forthcoming interest rate increases," said Citigroup convertible analyst Stuart Novick.

The revision to Citigroup's projection for outright convertible returns actually was revised in mid-May. At that time, Citigroup convertible analyst Adrian Miller said that, as a result of higher interest rates, wider credit spread assumptions and a slower small- to mid-cap stock price growth assumption, convertible returns would be muted.

Factors in the Citigroup analysts' expectations include a 75 basis point increase in interest rates through the rest of 2004 and another 150 basis points in 2005, with stagnant stock valuations.

Merrill Lynch convertible analysts are holding fast to their expectation of returns in the area of 6% to 9%, however.

"I note that year-to-date, [the Merrill convertible index] is up 3.5%, so that we are on pace to reach our target of 6% to 9%," said Yaw Debrah, head of Merrill's U.S. convertible research.

Outright convertible returns could make that in a bullish equity market, but he added - as expressed at the beginning of the year - with valuations high, a bearish tone in equities could cause as much as a 4% loss.

Yields will most likely subtract from overall performance, and if the benchmark 10-year Treasury yield hits 6% by year-end as Merrill strategists expect, that could deduct 2.8% from outright returns. In addition, if high-yield credit spreads widen to the 600 basis points by year-end as the strategists foresee, that would subtract another 2.7% in terms of outright performance.

Hedge funds in pain, but okay

Hedge funds were already bracing for their returns to continue a decline from the 12% to 15% seen in 2003, which was about half of what they saw in 2002. And, the convertible arbitrage strategy is now seen faring worse than expected, too, possibly into negative territory.

"We don't necessarily have a prognostication for convert arb funds, although if current trends hold - vol hanging around multi-year lows, interest rates likely to back up - we think that their returns will lag those of outright convert investors," said Citigroup's Novick.

"In the real world, though, many arb accounts have other investment strategies available to them, so some could wind up outperforming outrights."

Merrill's Debrah said his projection for hedge fund returns also remains in tact, noting convertible arbs are having to battle headwinds of low volatility, rising yields and rich valuations.

"On the hedge fund side, year to date, after taking account of our interest rate hedge, we are up about 2.1% before fees, which is in line with the lower end of our target of 4% to 8%," Debrah said.

The backup in Treasury yields, should the 10-year bond hit 6%, would take away 4.0% from hedged returns, he said, and another 4% could be subtracted from high-yield spread widening if the 600 basis points projection is reached.

Panic could create opportunity

Convertibles are in the midst of a revaluation process, although most market participants have stopped short of calling it a correction. That, along with other recent developments, can create opportunities. Some of the most severe backtracking of late, for instance, is a result of lacking takeover and/or dividend protection on individual convertibles.

Citigroup's Novick said cash takeover protection and dividend protection is becoming nearly universal in new issues as a result of big losses convertible arbitrage players experienced in the Kroll Inc. and Mandalay Resort Group all-cash takeovers. That left a field of issues without such features prey to deep price cuts that he thinks are worth considering.

"We happen to think there will be some good trading opportunities with issues that don't contain one or both types of protection and are being pressured by broad-based concerns over possible dividend initiations or increases, or cash takeovers," Novick said, noting that the Caesars Entertainment Inc. convertible floater came in 2 points on the Mandalay event.

Strategy shifts seen in progress

Going into 2004, lots of hedge fund players were expecting the play du jour to be in volatility, which many participants thought was sure to tick upward. Well, that hasn't panned out, so now there is a vigorous search for a new play, new strategy to boost performance.

"Volatility still is a big focal point, we are trying to develop a novel way of hedging volatility risk," said a portfolio manager at a huge fund-of-funds based in New York.

Onlookers from the sellside of the market are saying they don't expect volatility levels to get much better for the remainder of 2004 and certainly not during the summer - an historical low point each year.

While there has been lots of market buzz about liquidations among hedge funds, nothing dramatic has come to pass. Rather, new funds continue to crop up, albeit at a smaller pace than in 2002 and 2003, and many are oriented as multi-strategy or capital structure strategy funds that dip into convertibles to a lesser degree than in the past.

The manager of a new multi-strategy fund, which officially began building a book June 1, said convertibles are a smaller portion of the total than perhaps initially envisioned, but he's not given up on the asset class.

"As for our multi-strategy fund, given the limited opportunities in convert arb right now, we are going to try take advantage of the other strategies by 'cross fertilizing' them as best we can across the strategies," he said.

"That being said, we are just starting out, so it will take some time."

© 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.