UBS convertible analysts see opportunity as some junk credits stabilize in Q4

By Ronda Fears

Nashville, Tenn., Oct. 25 - Ballooning credit spreads over the past year should abate in the fourth quarter with higher-rated junk credits stabilizing and regaining some lost ground, said UBS Warburg convertible analysts. Investment-grade credits are likely to continue to rally for the remainder of the year, the analysts said in a recent paper, but rising defaults will inhibit a broad credit market recovery. Still, the analysts suggest that within the busted group of convertibles, which is well over half the market, there are bargains ripe for buying opportunity.

"We believe the indiscriminate credit spread widening will abate in the fourth quarter, and the stronger high yield credits should stabilize and regain some lost ground," the UBS analysts said. "We think the market has fully priced in the probability of default across the weaker credit spectrums, and more defensive issuers that are not facing liquidity crisis should benefit."

The overall credit quality profile of the convertible universe has improved in 2001, as UBS estimates 58% of the $199 billion market is investment grade - chiefly due to investment grade issues accounting for two-thirds of the record new issuance in 2001. High-grade convertibles made up less than half the market in 2000.

The rally of investment-grade credits is likely to continue through 2001, UBS analysts said, fueled by lower corporate credit cost brought on by the continued decline in interest rates. While benchmark U.S. Treasuries have gained 41 basis points so far this year, single-A credits have tightened by 35 basis points, the report stated.

But, the high yield market has been unable to hold gains scored earlier this year, retreating from a strong rally in credit spreads in January to levels seen in the 1998 credit market crisis, UBS analysts said. This year alone, credit spreads have blown out by an average of 340 basis points, as a result of record defaults.

Credits rated BB+ to BB widened 139 basis points to 407 basis points in September. UBS analysts said this credit spectrum is poised to tighten in the balance of 2001, as crossover credits should continue to benefit from a stabilizing economy, interest rate cuts and more downgrades from the investment-grade sector, all of which should result in strength, breadth and depth to this category. The BB- to B credits widened by a whopping 327 basis points to 789 basis points in September, reversing a strong tightening trend in early 2001, UBS analysts said. The group should stabilize at current levels, as fundamental improvement will likely be offset by downward credit rating pressure near term.

Housing the bulk of telecom and Internet companies, which continue to experience performance deterioration and a tight liquidity squeeze because of their funding shortfall, the B- to CCC+ credits widened by 210 basis points to 1091 basis points in September, UBS said.

The CCC and below credits widened by 577 basis points to 2,269 basis points in September, UBS said. The deterioration, UBS analysts said, reflects the quicker pace of bankruptcy for the struggling issuers with liquidity concerns instead of a general strengthening of the weakest credit spectrum.

"We expect the pace of bankruptcies to accelerate, and believe this credit spectrum, which far exceeds the 1998 credit-crisis level of 1483 basis points, will continue to be under pressure," said the UBS analysts in the report.

But, the UBS analysts said there are opportunities.

"We continue to favor selected companies in such technology sectors as telecommunications equipment, semiconductor, and software, whose recovery have been tenuous given market expectation of a prolonged downturn," said the UBS analysts in the report. "We believe investors should increase their exposure to these companies, which have solid cash flow generation, ample liquidity, and relatively modest leverage, yet whose convertibles continue to trade at busted levels because of the poor performance of the underlying equity."

The analysts said stronger companies will resume merger and acquisitions activities. High-yield companies with leading edge technology, whose recovery tends to lag more established companies with high-market capitalization, and whose valuations remain attractive, could prove to be compelling acquisition targets in the next few quarter. The UBS favorites among these possibilities are Juniper Networks, ONI Systems and CIENA.

Caution is still advisable, however.

"We continue to caution investors against the weaker credit segments, as we anticipate an avalanche of corporate defaults in the formerly high-growth telecommunications sector," the analysts stressed, noting that Standard & Poor's expects the corporate default rate to reach 10% in 2001, led by telecommunications issuers. "We believe the shakeout will be long and painful, resulting in a natural oligopoly, where only a handful of well-capitalized global telecom players will survive."

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