UBS convertible analysts: stocks may not recover soon, so play defensive

By Ronda Fears

Nashville, Tenn., Oct. 24 - While stocks have recently bounced from the lows seen immediately after the Sept. 11 terrorist attacks on the U.S., UBS Warburg convertible analysts believe the rally could be short-lived. Moreover, the analysts believe equities are over-discounted but it may take some time to see a recovery, so convertible investors are urged to play defensive.

The UBS analysts noted in a report Wednesday that issues in the consumer sector - historically a defensive sector - are likely to join the rout as consumer confidence more closely mirrors flagging corporate earnings. Thus, they suggest looking for defensive securities, strong balance sheets, more sheltered industry sectors like healthcare and strong fundamentals.

"The recent tragedies have dealt a blow to corporate earnings, which were already suffering from the slowing economy and a capital spending slowdown. The consumer segment, which had been relatively resilient in the first half, will likely join the rout, ushered by the lowest consumer confidence rating since 1990," the report said

"While poor fundamentals are likely to persist, we believe the equity market has over-discounted the longer-term prospects. These are supported by the multifaceted government incentives to individuals and ailing industries, as well as the continued aggressive interest rate cuts - 400 basis points so far in 2001 - that have brought the federal funds rate to 2.5%. Our economists expect further cuts of 50 basis points, which would bring the year-end rate to 2.0%.

"While we believe the stock market is deeply undervalued, we are concerned that the vulnerable U.S. economy - under increased pressure by the recent massive destruction, increased political tension, the threat of bioterrorism and war - may be heading for recession. With increased uncertainty, risk premium has risen, and the market trough may be long and arduous. Therefore, we believe the current equity market rally could be short-lived, and we urge investors to stay defensive, by investing in the following convertibles: defensive securities; defensive balance sheets; defensive industries; and selected fundamentals."

Convertible securities are inherently defensive instruments, as they cushion declines in the underlying stocks while providing higher upside potential than straight bonds, but there are types of convertibles that are more defensive than others. Specifically, the zero-coupon and discount senior convertibles of issuers with higher investment grade ratings, which have been issued in abundance in the past year, will give investors more protection in a declining market. Instead of the 70% upside to 40% downside profile typical of subordinated convertibles, the more defensive convertibles have closer to 50% upside to 20% downside participation, noted the UBS Warburg analysts.

These convertibles, in tandem with their vanilla debt counterparts, also have benefited from the interest rate cuts and most have short put features that limit exposure to as brief a period as one year. These convertibles, the UBS analysts added, have not only maintained investment value but appreciated, thereby offsetting the lackluster performance of the underlying stocks.

The top UBS picks for defensive convertibles are the Merrill Lynch zero-coupon issue due 2031, Verizon Communications' zero-coupon issue due 2021, Calpine Corp.'s zero-coupon issue due 2021 and Anadarko Petroleum Corp.'s zero-coupon issue due 2021.

Strong balance sheets are more difficult to find but the UBS analysts said they exist, even among busted issues and out-of-favor sectors. They suggest CIENA Corp.'s 3¾% convertible due 2008 and Network Associates' zero-coupon convertible due 2018 are "money-good" convertibles.

"We continue to believe money-good convertibles of busted issuers, even in the out-of-favor technology sector, are a downside-protected way to stay invested in the convertible market. We define money-good issuers as those with sufficient liquidity or resources to cover all of their debt obligations and near-term cash operating losses," the report said.

Healthcare and pharmaceuticals will continue to benefit from positive secular trends and should show solid execution despite near-term economic challenges, the UBS analysts said. They favor companies with a combination of a strong balance sheet to weather the current downturn and strong catalysts - products and the like - for near-term out-performance. Their picks are Caremark Rx Inc.'s convertible preferred due 2029, IVAX Corp.'s 5½% convertible note due 2007, the Johnson & Johnson zero-coupon exchangeable due 2020 that converts into Alza Corp. and the Medtronic Corp. 1¼% convertible note due 2021.

There also are situations where strong fundamentals will prevail in a sliding market. The UBS picks of this group are EchoStar Communications Corp.'s 4 7/8% convert due 2007, the Jardine Matheson 4.75% exchangeable due 2007 that converts into J.P. Morgan Chase, the Liberty Media 3¾% exchangeable due 2030 that converts into Sprint PCS and the Unocal Corp. 6.7% convert due 2026.

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