The convertible bond market provided lackluster returns in 2005, leading many investors to question the benefits of the asset class. Some of the many factors that created a difficult environment in 2005 were rising short-term interest rates, declining equity volatility, and selling pressure from leveraged convertible arbitrage hedge funds. We're pleased to report that many of these difficulties are now behind the convertible market, as the first half of 2006 has illustrated the continued benefits of the asset class. In this report we provide details on the factors affecting valuation of convertible securities and the opportunities in the current market environment.
Convertible Bonds: The Benefits of Hybrid Characteristics
The performance of convertible securities during the first half of 2006 clearly demonstrates the benefits of the asset class. The hybrid nature of convertible bonds typically offers upside appreciation in rising equity markets but can also provide downside protection during declining equity markets. During the positive equity markets of the first quarter of 2006, the convertible bond universe provided gains that exceeded that of the broad equity markets. During the second quarter, the equity market experienced some volatility when the prospect of higher inflation heightened fears that the Fed will continue to raise rates and send the U.S. and global economy into a slowdown or recession. As for the macro concerns, we believe that the larger macro economic picture remains sound and the current economic expansion will continue at a moderate pace. And as for convertible securities, we were pleased with the downside protection that they provided during this volatile period. Over the second quarter, convertible bonds performed exactly as expected. The convertible market provided downside protection and held up much better than the equity market.
Convertible Market Overview
New convertible bond issuance remains relatively light; however, we are seeing improvements over last year's low issuance level. During the first half of 2005, new convertible issuance totaled $14.2 billion, while the first half of 2006 saw new issuance that amounted to $35.2 billion, an increase of 148%. Convertible issuance had suffered over the last few years, as the relatively low interest rate environment led many companies to use the straight bond market as a method of raising capital. With interest rates moving higher, we expect that issuance will continue to improve and provide a wider opportunity set for convertible investors.
While the performance of the overall convertible market has been strong, we have witnessed a divergence of performance between investment grade and speculative grade convertible bonds. As shown in the adjacent chart, the lower quality speculative grade issues have driven performance for the convertible market in 2006. We believe this is an unsustainable trend. With the economy in the mid-cycle growth phase, higher-quality companies with stronger balance sheets will stand to benefit relative to lower- quality, more-speculative grade issues. It is often the case that lower quality issues experience a relief rally in the recovery phase of the economy, as seen in 2003 and 2004, but with the economy moving into the mid-cycle growth phase, we believe that higher- quality issues will prosper.
Convertible Valuations
Convertible bonds began the year at very attractive valuation levels as a result of market dynamics that occurred towards the end of 2004 and throughout 2005. Convertible valuations declined in the 2004/2005 period as declining volatility and rising interest rates put pressure on leveraged convertible arbitrage hedge funds. Volatility is an important component of the pricing of a convertible bond. Lower volatility diminishes the value of the conversion feature (or optionality) of a convertible issue. As the chart shows, market volatility was very low and declining over this period, reducing the value of the conversion feature of convertible bonds. 
This occurred at the same time that short-term interest rates were rising, causing leveraged strategies to face higher borrowing costs.
This dynamic of higher borrowing costs and lower volatility led to disappointing returns for the leveraged convertible arbitrage strategies, which in turn spurred redemptions and forced aggressive selling of convertibles. This selling pressure depressed the prices of convertible bonds and created an excellent opportunity for long-term convertible bond investors.
Capitalizing on the Valuation Opportunity
This chart illustrates our assessment of fair value relative to the current market price for convertible securities. While convertible bond returns for 2005 were somewhat disappointing due to the market actions described above, we believed that at the end of 2005, convertible bonds were as attractively valued as they have been in more than 15 years.
In the first half of 2006, we have seen the positive benefits of this opportunity. As hedge fund selling has begun to subside and market volatility has increased, convertible bonds have benefited. The valuation chart above illustrates the improvement of convertible bond valuations, which has translated into attractive returns for convertible bond investors year-to-date, providing superior returns relative to the broad equity markets for the first half of 2006.
Convertible Market Outlook and Portfolio Positioning
We continue to have a constructive economic outlook. We believe the economy remains in the mid-cycle growth phase, which is characterized by steady GDP growth and continued corporate earnings growth. We believe that the see-saw pattern we have experienced in the market over the past several months will resolve itself with the market moving higher. While performance within the convertible bond market has been aided by the improvement of valuations recently, we continue to see the convertible bond market trading below our estimate of fair value. We believe that convertible bond investors stand to benefit from further improving valuations as well as participation in an improving equity market.
Our convertible strategies are positioned to benefit from this economic backdrop. We have been favoring higher-quality issues that should perform well, as companies with stronger balance sheets should continue to prosper in a slower, but positive, steady growth environment. We are also favoring convertible issues that provide good equity sensitivity. These issues stand to benefit from appreciation in the equity markets.
Convertible bonds continue to be an important component in an investment portfolio. The hybrid nature of convertible bonds offers investors an excellent opportunity to manage the risk/reward relationship. Structured properly, a convertible bond portfolio will participate in the upside movements in equities but help protect principal should the equity market turn south.