"We continue to favor higher-quality businesses with lower balance-sheet risks and more sustainable growth outlooks."
U.S. convertible securities1 have posted positive returns this year with the Merrill Lynch All Convertibles Index (VXA0) gaining 5.87% through November compared with a 6.23% gain in the S&P 500 Index. In November, the convertible index fell 3.85% compared with a 4.18% drop in the S&P 500, which again showed how convertibles can provide potential downside protection during difficult months in the equity market while they can participate in gains in good months.
2007 Returns (as of 11/30/07)
Source: Russell Mellon Analytics
New Issuance
We continue to see positive net issuance this year, which contrasts with the last three years in which redemptions outweighed new issues. Total new issuance this year is $77.4 billion2, more than the entire 2006 amount of $70.7 billion, according to Merrill Lynch. The value of convertible securities outstanding at the end of November was $305.5 billion, a level higher than the end of any year in the past decade. We are cautiously optimistic on the potential for continued improvement in issuance and believe that higher credit spreads and the pickup in stock volatility further support this belief.
Credit Quality
While below investment-grade convertibles have dominated the past five years, for most of the second half of this year higher-quality, investment-grade convertibles outperformed the lower-quality speculative-grade convertibles because of concerns over a credit crunch and its potential drag on the U.S. economy. As investors moved to favor higher quality investments, the Merrill Lynch All Investment Grade Index outperformed the Merrill Lynch All Speculative Grade Index by 246 basis points in November and now leads by 84 basis points this year. Our convertible strategies were positioned to benefit from this, as we have favored higher quality convertibles.
As you can see from the chart below, the convertible market continues to provide ample opportunities to invest in both investment-grade and below investment-grade companies.
Credit Quality (as of 11/30/07)
Source: Merrill Lynch
Sector Performance
Cyclical materials companies have led the way in gains this year (see chart). However, leadership is changing to increasingly favor growth companies over value companies and to favor less leveraged businesses with less cyclical cash-flow streams.
Indeed, November's sector performance reflected the market's mounting concerns over the challenging macro economic backdrop. The traditionally defensive consumer staples sector and the health care sector emerged as the best performers. On the other hand, cyclical sectors like materials and transportation ranked lowest. The consumer discretionary and financials sectors continued to feel the pressure from the housing and credit market, lagging the broad convertible market for the month.
U.S. Convertibles Sector Returns (YTD through 11/30/07)
Source: Merrill Lynch
Outlook
While the markets and the media have continued to focus on the negative news coming out of the housing and financials sectors, much of the U.S. economy continues to do quite well. The falling U.S. dollar has benefited many sectors and trade has added to U.S. GDP during recent quarters for the first time in some years. We remain conscious of the risks facing the consumer but thus far the data on payrolls, unemployment claims and wage growth continue to be relatively favorable. Given that our economic views have not changed significantly, we have not made major changes to the positioning of our convertible strategies. We continue to favor higher quality businesses with lower balance-sheet risks and more sustainable growth outlooks.
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 interest income, the opportunity for equity participation when stocks rise, and potential downside protection when stocks fall.
2Merrill Lynch
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 non-investment grade convertible market.
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.
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