Outlook 2010: U.S. convertible secondary market set for 'milder' year after stellar 2009 returns

By Rebecca Melvin

New York, Dec. 31 - Following the painful plunge of 2008 and dramatic rebound in 2009, the convertible bond market of 2010 is expected to be much milder, more normal, but decent, compared to the swings of the last two years, market sources say.

Return on an outright basis was a remarkable 48% for the year through Dec. 21, and hedged return was about 33%, according to Bank of America Merrill Lynch research.

Barclays Capital research said convertible arbitrage strategy returned an even greater 39.17%. And anecdotally, there were convert arb players that outpaced the 45% return of outrights, a Connecticut-based sellsider said.

Those players that had the right names, and higher leverage at the right time, did even better, the sellsider said.

The stellar performance of the convertible asset class in 2009 was tied to a strong rebound in equities and premium expansion that came with an incredible tightening of credit spreads, sources said.

For 2010, "further normalization" is expected, as the economy recovers, Barclays Capital said. "Credit and equity, the two major positive drivers of convert returns in 2009, are likely to be more subdued in 2010," according to the bank, which expects 2010 outright return to be just 3.5% to 7.5%, assuming the S&P 500 stock index ends the year in the range of 1100 to 1200.

Meanwhile, convert arb will likely outperform long-only strategies in 2010, the Barclays analysts, Venu Krishna, Manoj Shivdasani and Peng Cheng, wrote in their outlook research published Dec. 16.

Bank of America Merrill Lynch, on the other hand, is looking for outright convertible return of about 13%, using its base case scenario predicting stocks will go up 14.5%, a climb that would boost the S&P 500 to about 1275 by the end of the year, according to Bank of America Merrill Lynch convertibles analyst Tatyana Hube.

Delta-neutral hedged return for 2010 will be a "very muted" 6%, Hube said. It will return 7% using Bank of America Merrill Lynch's "pessimistic" scenario of flat stock markets.

Delta, gamma, coupons, and to a smaller extent, further tightening of spreads are expected to be the highest components of return in 2010, Hube wrote.

Hoping for more than 'mild'

Others are hoping for more than mild, and they don't seem to appreciate the idea of calm even after suffering through 2008.

"Calm isn't interesting," said Wedbush Morgan Securities managing director Thomas Murphy.

"The secondary market will continue to perform well in the near- to intermediate-term as short-term funding rates remain at historic lows and the convertible strategy, both arb and fundamental, continue to perform well, attracting new money to the strategy," Wedbush's Murphy said.

Murphy, who is located in Los Angeles, predicted that given the amazing performance of the convertible asset class in 2009, more players will allocate more funds to the space in 2010.

Others agreed. "The potential for 2010 is much less great, but confidence has returned, and money is flowing in. The inflows may drive performance," a New York-based outright portfolio manager said.

The outright player said the swings in the convertible market have been more pronounced in the last decade than previously due to the rise of hedge funds and leverage...and the widespread use of convertibles in hedged strategies.

"Convertibles provide a natural hedge - even before one shorts the stock. But flows in and out of hedge funds and convertible arbitrage run hot and cold," the portfolio manager said.

After the "crash" of 2008, a lot of hedge fund money came out of the space and the ratio of hedged to outright players dropped to about 60:40 from 75:25. Others say that split is probably closer to 50:50.

"Convert arb was a loser in 2008 because at the time, arb accounts represented approximately 75% of the convertible investor community. Credit melted and many prime brokers no longer accepted illiquid converts as collateral. Combined with the fact that many accounts faced severe redemption requests, it's easy to see why the selloff was so pronounced," Wedbush's Murphy said.

Obviously, outrights had a glorious 2009, benefiting from tighter spreads and higher equities, and enjoying "more pricing influence than at any time in the past 20 years or so, which is maybe the last time they divided the market with arbs," a New York-based sellsider said.

Redemptions by investors that have plagued the convert space in the past, notably in 2005 and 2008, should not be a big factor in 2010, sources said.

Other drivers in 2009

Convert arb also performed well in 2009 because short-term funding rates declined to historic lows, leverage returned and new-issue terms became much more attractive, according to Murphy.

The biggest positive surprise for both outright and hedge returns was a sharp recovery in credit, with high-yield spreads tightening from about 1,800 basis points at the end of 2008 to about 700 bps in mid-December, according to Bank of America Merrill Lynch's Hube.

Also helping both outright and hedge returns was that the convertible market richened from being 4% cheap at the end of 2008 to about 1.4% cheap most recently.

A New York-based sellside trader objected to the use of the term cheap to describe market pricing, saying that the convert market was priced relative to where risk was. As risk perception changed, valuation changed.

"Cheap is such a relative term. The question is where they are in context with pricing trends," the sellsider said.

Additionally, although the volatility index tumbled from about 40% at the end of 2008 to about 20% most recently, the convertible market didn't suffer from this sharply lower volatility since many converts had already had very low vol. caps imposed on them by investors.

Also in 2009, most convertibles were "busted" at the beginning of the year, which meant they had practically no vol. sensitivity and acted more like traditional bonds.

But players don't expect this condition to continue into 2010, and they see volatility as a big wildcard this year as usual (see related story).

Was 2009 really good?

One New York-based sellside analyst argued with the premise that convertibles had a good year.

"Convertibles have not been good at all. It all depends on what your reference is. You have essentially a shrinking market, with no real calendar. It obviously performed well. But in order to make a case for convertibles in general, you have to point to how this asset class is unique in a given way. In other words, what did the asset class do differently from high yield, CDS, spreads, vols, or what have you," the analyst said.

"You've got high-yield bonds up 55%, outright convertibles up just shy of 50%, equities up not much to speak of at 25%. Then you've got converts starting last year with deltas of 47% and most of the characteristics tied to fixed income markets.

"If you took your portfolio and went home at the beginning of '09, you'd be up 50%. There's nothing unique, valuations were cheap because spreads were so low," the analyst said.

But another sellsider pointed out that given that convertibles are a derivative product, broader factors in the credit and equity markets and the patterns there are relevant, as are capital flows into and out of alternative products and the broad trends that influence them.

Competition from the high-yield market was very strong and definitely a factor. It took market share away from the convertible bond primary market, which had had a good spring and was expected to have a good fall but couldn't draw interest away from high yield.

Currently the risk appetite is still there, and with interest rates still low, that is not expected to change in the first half of 2010, according to some.

Overall, the swings in convertible arbitrage in '08 and '09 were due to unusual, systemic factors such as the blowout in credit spreads, the fall of Bear Stearns and Lehman Brothers and the general liquidity crisis that forced deleveraging, the sellsider said.

"These were hundred-year events so to speak," he said.

Best trades of 2009

The best trades in 2009 were mostly short-dated convertibles of relatively strong companies, according to one New York-based sellsider. That paper included bonds with puts or maturity in 18 months to 24 months or less for companies with strong balance sheets and adequate cash balances.

"They were trading at severely dislocated valuations at the beginning of the year," the sellsider said.

Also anything financial was a good trade, he said.

An example of a top winner in 2009 was Advanced Micro Devices Inc. Pricing of the Sunnyvale, Calif.-based chip maker's 6% convertibles and 5.75% convertible was in the 30s at the start of 2009.

Both bonds steadily crept up, and then when the company started a cash tender for the 5.75% bonds due 2012 in November, that paper zoomed up to near par, while the still-outstanding 6% paper due 2015 is now also near par.

"Anyone who bought those when you couldn't give them away made a killing," a sellsider said.

Also on an outright basis, Hutchinson Technology Inc.'s 3.25% convertibles due 2026 did very well. They started 2009 at around 30 and went to 81.

A lot of convertible paper made dramatic moves upward, but most didn't make 200% moves, a sellsider said.

"The convert market is not going to improve on the broad basis that it did in 2009. It's not going to outperform again," a sellsider said.

A hedge name that performed well was Cephalon Inc. The convertible paper's bumpy ride made it a lucrative play. Pricing of the older paper still hasn't recovered to levels of late 2008 or early 2009.

The Frazer, Pa.-based biopharmaceutical company launched and priced new convertible paper in May. That $435 million deal of 2.5% convertibles due 2014 now stands at about 109.

Cephalon 2% paper due 2015 is at about 136 from 170 in January, and there are also the Cephalon A and B tranches of 0% paper due 2033.

Drivers in 2010

Given milder credit and equity markets, drivers of return in the convertibles market in 2010 are going to be more dependent on relative value, security selection, tactical sector rotation, cap-structure trades, primary market cheapness and event driven opportunities, Barclays Capital analysts said.

Their recommendation for active portfolio management is to reap incremental value in credit, but focus on alpha generation through equity selection, and to remain defensive through the first half.

They suggest increasing exposure after an early correction. They also said shorter-term tactical strategies will be important in 2010, as well as being overweight high yield, underweight investment grade, and maintaining a balanced stance through credit-oriented and balanced convert profiles.

Given the predicted outlook, one convertibles outright player said, "[This year] will seem easier than 2009. It may even be easier to keep up with the convertible benchmarks in 2010."

Nevertheless, he added strong caveats. "...but the danger is, as usual, in potential events that are not anticipated by the market."

"Convertibles are still 'cheap' in a theoretical sense, but nowhere near as cheap as at the start of 2009, nor are credit spreads extraordinarily wide, nor are equities unusually cheap. So the 2009 tailwinds, born of fear are missing. Instead, complacent traders/speculators/investors will leave themselves open to traditional blunders," the outright player said.

Wildcards in 2010

Potential wildcards, in addition to the consistently present volatility wildcard, include an increased potential of a war in the Middle East, potential withdrawal of peripheral E.U. countries from the Eurozone, potential recovery of the Japanese economy and or capital markets, potential slowdown in China, potential bear market in stocks if the Fed raises rates faster than expected - since stocks soared while earnings were down, and stocks may be weak while earnings recover - and finally, potential credit downgrades of sovereign nations and potential large foreign exchange fluctuations, the buysider said.

"My guess is that the Fed either raises rates sooner than is presently expected, or that the Fed simply gives guidance that rates will soon be increased. I'm not sure whether this causes a bear market, but it probably means reduced P/E ratios, hence stocks aren't likely to rise as fast as corporate earnings, which is in contrast to the 2009 bull market that began while earnings were bottoming," the buysider said.

While interest rates have the ability to be a wildcard, Fed chairman Ben Bernanke never lets an opportunity pass to say that inflation is subdued, a sellsider said.

Bank of America Merrill Lynch's U.S. economics team projects GDP to grow at 3.2% in 2010, well behind what is common when coming out of a major recession. Concurrently, it expects interest rates to stay low and rise slowly in 2011.

The high-yield market is also a wildcard. If high yield continues to be the bargain that it is now, it will continue to hamper new issuance levels in the convertibles market, and more new issuance is a key component of getting more vibrant performance in convertibles, sources said.

Credit has tightened significantly (in many cases to pre-collapse levels) opening the high-yield market to many issuers who were not able to access it over the last 12 months to 18 months. If credit continues to tighten, new convertible issuance could be negatively impacted.

Issuance is going to be a wildcard in 2010, not simply in quantity, but also in quality of the issues, a source said.

Supply is very much influencing price. The lackluster issuance in '08 and '09 as well as the spate of buybacks and retirements has winnowed out the shorter end of the universe, leaving it somewhat long, heavy, a sellsider said.

Opportunities in 2010

The convertibles market right now has a dearth of better credit names. Investment-grade bonds have been getting better and will continue to do so. There are no sellers and a lot of buyers.

Some of the more glaring mispricings will be arbitraged by that. There was certainly more IG retired in the past 12 months than has been issued, and demand for convertibles is exceeding supply.

"This is hardly an atypical situation historically. A difference is that traditional long-only institutions and cross-over accounts have driven much of the demand in 2009. Now, however, hedge funds are also clamoring for convertibles. Terms of new issues remain good. If terms get better for issuers and worse for buyers, this will plant the seeds of opportunities for investors who remain on the lookout for bargains and who have a sense of value," an outright player said.

One West Coast-based sellsider sees opportunity in the area of mid-cap size companies.

"There's a ton of them in various sectors such as health care, tech, retail. And there are pricing dislocations which can be taken advantage of," the sellsider said.

New money is coming into the product from money markets, Treasuries, etc., and he predicted this trend will continue.

"My sense is that there is going to be new money coming in. Still, there isn't enough product, and historically that has been the problem with converts, which are a great product," the sellsider said.

Given the existing market is relatively small, prices will appreciate. Existing converts will be bid up some more, and companies will try to use the convertible market for refinancing just as they have been doing, he said.

"There is huge demand for refinancing," the sellsider said.

If there is attractive issuance and more balanced issuance, with the issues reliant on stocks, even the credit-sensitive busted convertibles could do better.

Possible sellside consolidation

In 2008, there were a lot of people who left big shops to start their own businesses, and they set up agency shops with no capital commitment.

"Guys on the buyside and also on the sellside wanted to sell; so these little shops did well even though they were businesses with no capital and wouldn't front run their orders ahead of them," a West Coast-based sellsider said.

But now the advantages for the buyside to give their orders to small shops are reduced because the primary calendar started heating up.

"The new issues provided instant profit of 5, 6 or 7 points," the sellsider said, so there will be incentive for the buyside to go with the bigger firms.

In addition, if the bigger shops get more aggressive, some of the smaller players may get their seats back on the bulge bracket, the sellsider said.

A buysider agreed. "Major sellside firms are considerably less 'major' than they were, so there is room for smaller sellside broker/dealers to capture market share. But the smaller players are at risk if the bulge-bracket firms re-expand their teams and again provide capital for trading," the buysider said.

But Murphy of Wedbush said, "We think there is an undersupply of high-quality broker-dealers serving the equity-linked needs in the small and mid-cap space. We intend to fill this need with the recent creation of the convertibles, options, and distressed securities division here at Wedbush."

Mentioned in this article:

Advanced Micro Devices Inc. NYSE: AMD

Hutchinson Technology Inc. Nasdaq: HTCH

Cephalon Inc. Nasdaq: CEPH

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