"The market remained volatile against a challenging economic environment, which demonstrated the benefits of the hybrid nature of convertible securities."
U.S. convertible securities1, as measured by the Merrill Lynch All Convertibles Index, declined 3.25% in the fourth quarter but slightly outperformed the 3.3% fall in the broad S&P 500 Index. Investors questioned whether the Fed's continued interest rate easing of 50 basis points during the quarter was sufficient to fight economic weakness driven by losses in subprime lending, recession in housing, rising oil prices, tighter credit, and the effect of these factors on consumers. The market remained volatile against a challenging economic environment, which demonstrated the benefits of the hybrid nature of convertible securities. For the year, convertibles were in positive territory with a 4.5% return compared with 5.5% for the S&P 500.
2007 Returns (as of 12/31/07)
Volatility
Volatility is an important component of the pricing of a convertible bond. Higher volatility increases the value of the conversion feature (or optionality) of a convertible issue. Volatility, as measured by the CBOE Volatility Index (VIX), rose 27% for the quarter to 23.2. The VIX index started the quarter around 16 and spiked to a four-year high of 31 in late November and remained at elevated levels throughout December.
New Issuance
The convertible primary market remained robust during the fourth quarter, providing investors with a decent universe in which to invest. As secondary market valuations held relatively stable near fair value and issuers sought timely financing, the primary market terms remained quite attractive. The total new issuance for the fourth quarter was valued at $27.4 billion, bringing the year-to-date total to $95.12 billion2, second only to 2001. Reflecting the overall health of the convertible market, net issuance in 2007 was a strong positive at $18.3 billion, in contrast to the previous three years during which redemptions outweighed new issues.
Credit Quality
As in the third quarter, higher quality convertibles demonstrated greater resilience in the fourth quarter amid concerns about the negative impacts from credit crunch and the recessionary housing market. Speculative-grade convertibles lost 4.9% in the quarter while investment-grade convertibles retreated only 2.3%, according to Merrill Lynch indexes.
As you can see from the chart below, the convertible market remains fairly well balanced between investment-grade and below investment-grade securities.
Credit Quality (as of 12/31/07)
Source: Merrill Lynch Convertible Research
Outlook and Positioning
Despite the headline-grabbing woes surrounding the economy and the political landscape abroad, we believe there are still many reasons to be excited about various parts of the economy and select investment opportunities. Within our convertible allocations, we favor growth and higher-quality global businesses where we still see reasonably valued companies with the ability to generate return on capital to expand their worth. We continue to favor technology and communications sectors and we remain very selective regarding financial and consumer sectors.
1Convertible bonds are interest-paying securities, similar to corporate bonds, in which investors have the option to turn the bonds into a predetermined number of shares. The hybrid nature of the securities offers investors the principal-protection and income characteristics of bonds with the opportunity for higher returns if the issuer's stock price rises.
2Merrill Lynch "U.S. Convertible Monthly: December and 4Q 2007," 1/4/2008
Past performance is no guarantee of future results. Current performance may be lower or higher than the performance quoted.
Index Definitions
The U.S. convertible market is represented by the Merrill Lynch All U.S. Convertible Index (VXA0), which is comprised of approximately 700 issues of only convertible bonds and preferreds of all qualities. The stock market is represented by the U.S. S&P 500 Index, an unmanaged index generally considered representative of the domestic large-cap stock market. The Merrill Lynch All Investment Grade Index (VXA1) includes about 140 convertible securities with investment-grade credit ratings to represent the investment-grade convertible market. The Merrill Lynch All Speculative Grade Index (VXA2) includes about 270 convertible securities and represents the noninvestment grade convertible market. The VIX Index measures expectations of near-term volatility conveyed by S&P 500 stock index option prices. The VIX Index is generally considered to be a barometer of investor sentiment and equity market volatility.
Unmanaged index returns assume reinvestment of any and all distributions and do not reflect fees, expenses or sales charges. Investors cannot invest directly in an index.
There are certain risks associated with an investment in a convertible bond such as default risk—that the company issuing a convertible security may be unable to repay principal and interest—and interest rate risk—that the convertible may decrease in value if interest rates increase.
This commentary is presented for informational purposes only and should not be considered investment advice.
Calamos Advisors LLC
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