Convertible Market Overview
In the face of lackluster performance by the U.S. stock and bond markets, convertible-based strategies did not perform well. Put simply, during 2005 neither the stock nor straight bond markets could sustain much strength against the strong headwind of rising interest rates, and convertibles fared worse than their more traditional counterparts. In addition to the concerns associated with rising interest rates and a directionless equity market, convertibles also suffered from forced selling within the convertible arbitrage hedge fund community, driving valuations downward in the first part of the year. The end result was a flat 2005 performance for convertibles—and an asset class that is as undervalued as we have seen in decades.
In past periods, rising interest rates have often coincided with higher stock prices, allowing convertibles to perform well even with a poor bond market. The most recent example of such an environment occurred in 1999. Unfortunately, 2005 behaved more like 1994, when rising rates and a flat stock market held back convertibles. The similarity to 1994 has a bright side however, when considered in the context of the market cycle. Then, after the Fed stopped raising rates, the middle-growth phase of the economy ensued, producing good returns for our convertible strategies. Given that the Fed is once again nearing the end of its interest rate hikes, we believe this bodes well for convertibles, as discussed further below.
Over the long term, convertibles have delivered capital protection to investors during downturns and participation in the up phase, resulting in exceptional risk-adjusted returns. We remain confident that in the future, convertible based strategies will continue to meet our clients' objective of providing significant total returns while controlling risk.
Convertible Market Outlook
The outlook for convertible securities in 2006 is promising. As noted above, we assess convertibles to currently be significantly undervalued relative to their underlying equity. In the past, we have experienced a "catch-up" phase, where the asset class returns to more normal historic valuation ranges and provides a solid return to investors. A number of factors point to the possibility for stronger performance in 2006. For one, it appears that the unwinding of the levered convertible arbitrage hedge funds has finally run its course. Also, the Fed's nearing of the completion of interest rate rises should give the equity markets the potential to gain more market recognition—as well as boost levels of volatility. Both these events have the potential to boost convertible valuations as well. Relative to the pure equity market, we believe convertibles will track the upside we are anticipating among stocks, especially should the return to normal valuations provide convertibles with an additional boost of appreciation. Relative to straight bonds, we believe valuations are overall fair in the corporate bond space, although there are special situation opportunities that research can uncover. As in 2005, we thus are focused on convertibles with greater equity sensitivity, which we believe have a better balance between risk and reward than do convertibles that tout more bond-like characteristics.
Convertible Market Review—Fourth Quarter 2005
The convertible market was up 0.46% in the 4th quarter, bringing the 2005 return to 1.01%, as measured by the broad based Merrill Lynch All Convertible Index (VXA0). Several market dynamics impacting the convertible market (valuations, new issuance, and credit quality) limited some of the returns in 2005. These same factors also lead us to believe that convertible bonds remain a very attractive asset class, which should provide attractive risk/reward for investors going forward.
One of the factors impacting the convertible market in the 4th quarter, as well as throughout 2005, has been the selling pressure from hedge funds employing convertible arbitrage. Convertible arbitrage is a popular hedge fund strategy that has a history of delivering consistent returns with low risk. In the recent market environment (marked by low interest rates and low volatility), the returns that convertible arbitrage hedge funds have produced have disappointed investors. This disappointment has led to redemptions, which in turn has led to the hedge fund community selling into the convertible market. This selling pressure has depressed prices in the convertible bond market, and created some of the best valuations we have seen since 1987. The chart below illustrates this valuation gap. Historically, we have seen the convertible market trade between a 1.5% discount to a 2.5% premium to our fair value estimate. As you can see, valuations have declined within the convertible market recently. As of year end, according to our valuation tools, the convertible market is 2.75% undervalued. This selling pressure and decline in valuations has limited the returns in the convertible market this year. A similar phenomenon happened in 1994, as the Federal Reserve was aggressively raising rates, convertible valuations declined. The valuation collapse that occurred in 1994 was relatively short lived and convertibles returned to more normal valuations.
While there is still some hedge fund selling in the convertible market, it is not as intense as it was towards the beginning of the year. We have seen valuations improve somewhat over the past several months, however, valuations still remain attractive.
While convertible issuance remains light, we did see issuance strengthen in the 4th quarter this year. New issuance for the full year 2005 came in at $37.4 billion, below the level of 2004. While the full year results are disappointing, November and December were the two best issuance months of the year. We are not surprised by the light issuance given the fact that many corporations have plenty of cash on hand and that we remain in a low interest rate environment. For those companies looking to raise capital, many have chosen to issue straight debt as interest rates (or their cost) are appealing (and no potential for equity dilution). We remain hopeful the issuance we saw in November and December continue since greater issuance leads to broader opportunities in which we can invest.
Returns by credit quality have moved toward where we have thought in the 4th quarter and full year 2005. The chart below illustrates the returns of investment grade and speculative grade convertibles over the past few years.
As you can see, investment grade convertible securities have outperformed speculative grade in 2005, something that has not happened in three years. Our investment process, which focuses on quality and sustainability and avoids distressed debt situations, stands to benefit from the current environment. In both the 4th quarter and full year, the market has shifted and has rewarded issues with better quality. We view this as a positive sign for the market and provides further evidence that our portfolio positioning and macro economic views are on target.
Current Portfolio Positioning/Outlook
The portfolio is favoring higher quality and equity sensitivity. We believe the economy is on firm footing and is in the middle stages of the economic cycle. With this economic backdrop, higher quality issues should perform well, as companies with stronger balance sheets should continue to prosper in a positive, but slowing growth environment. Many of the speculative grade issues benefited from the recovery rally in 2003/2004, but moving forward, we believe it will be the higher quality names that benefit from a steadily growing economy. We are also favoring issues with good equity sensitivity that will benefit from positive movements in the equity markets.
The hybrid nature of convertible bonds offers investors an excellent opportunity to manage the risk/reward relationship. Structured properly, a convertible portfolio will participate in the upside movement in equities, but help protect principal should the equity markets turn south.
Our outlook for convertible bonds is very favorable. We believe that the attractive valuations mentioned earlier are providing an excellent opportunity for investors today. Our experience in the convertible market suggests that the valuations of convertible bonds will revert to historical norms. As this occurs, current convertible bond holders will benefit as valuations improve. We continue to be optimistic that the increase in new issuance we saw in November and December continues. As interest rates rise, we believe more corporate CEO's and CFO's will begin to look to the convertible market as an effective way to raise capital, increasing the appeal of convertible securities.