Convertibles avoid worst of damage to underlying equities, Merrill says

By Ronda Fears

Nashville, Tenn., July 1 - Accounting problems, tensions in the Middle East and ongoing credit downgrades have wreaked havoc on the equity markets this year. But Merrill Lynch & Co. analysts said the convertible market's average delta of 35% helped to limit the loss in second quarter to 7.5%, while the underlying equities crashed 24.9%.

For the first half of 2002, convertibles are down 8.4% compared to a loss in their underlying equities of 29.4%, according to Merrill.

"Adelphia Communications, CMS Energy, WorldCom, Xerox. The list of outrageous accounting scandals continued to lengthen during second quarter, weighing down on the markets and casting a pall over all market sectors," noted Merrill convertible analysts Yaw Debrah and Tatyana Hube in a report Monday.

"The slightest rumor of accounting problems was enough to cause investors to punish even the mightiest blue chip stock."

Credit pressures also weighed on the market.

"After receiving criticism for their handling of Enron, Moody's and S&P continued to demand more disclosure concerning off-balance sheet accounting and limited partnerships for companies under review. Any hint of a credit downgrade sent stocks tumbling as investors tried to steer clear of the next disaster," the analysts said.

"During the second quarter, many seemingly secure companies, including Tyco, saw their debt downgraded to junk. However, the average rating of the [Merrill] convertible index remained at BBB-."

Average investment value premium hit a historical low of 21.2% during the quarter, while average conversion premium reached a record high 75%.

But that provided the shelter.

Angels continued to fall as Moody's and S&P continued to downgrade companies to below

investment grade, the analysts noted. Speculative grade convertibles declined 9.9% during the quarter, while investment grade issues dropped 5.0%.

"A predominance of credit downgrades over upgrades continued to weigh on yield alternative convertibles during the quarter," the analysts said.

Nonetheless, yield-alternative convertibles dropped a modest 4.1%, providing strong downside support against the underlying equities, which fell 29.8%.

Total-return convertibles declined by 10.4% compared to a drop in the underlying equities of 21.5%.

Equity alternatives with high stock sensitivity dropped 13.0%, closely mirrored the decline in the underlying equities of 16.2%.

The analysts noted, however, that the flight to quality continued during second quarter, as the Merrill Lynch government and corporate bond index increased 3.8% while the Merrill Lynch high yield index declined 6.1%.

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