"The bouncing equity market activity demonstrated the risk-management benefit of convertible securities."
U.S. convertible securities1 posted positive returns this year with the Merrill Lynch All Convertibles Index (VXA0) gaining 10.12% through October compared with a 10.86% gain in the S&P 500 Index. The bouncing equity market activity demonstrated the risk-management benefit of convertible securities. Convertibles participated in the upside with the rising equity markets and demonstrated limited downside during difficult months. As we look at the convertible market today, it continues to offer favorable opportunities to structure the attractive risk/reward profile investors look for from these securities.
2007 Returns (as of 10/31/07)
Source: Russell Analytics
New Issuance
Convertible issuance has edged higher over the past 12 months or so after disappointing issuance and high redemption activity during 2003, 2004 and 2005, when volatility was low and companies decided to take advantage of the easy conditions in the straight corporate debt market. Issuance in 2007 has added up to $71.6 billion in the first 10 months of the year, more than the total in all of last year.2 Importantly, we continue to see positive net issuance this year, which contrasts with the last three years where redemptions outweighed new issues. The amount of convertible securities outstanding at the end of October was $318.9 billion3, a level higher than the end of any previous years. We remain cautiously optimistic on the potential for a continued improvement in issuance and feel that higher credit spreads and the pickup in stock volatility has created better conditions.
U.S. Convertible Issuance (as of 10/31/07)
Source: Merrill Lynch Convertible Research
Global issuance was $113.5 billion through the third quarter while only $110 billion was issued in all of 2006, according to Merrill Lynch. We are encouraged by signs of increasing investment opportunities outside the United States, especially in Asia where we saw record issuance in the second quarter.
Credit Quality
While below investment-grade has dominated for much of the past five years, for the better part of the third quarter higher quality investment-grade convertibles outperformed the lower quality speculative-grade convertibles because of concerns over a credit crunch and a potential drag on the U.S. economy. Investment-grade convertibles gained 2.7% while speculative grade fell -0.4% in the third quarter. Year-to-date, investment grade and speculative grade are in positive territory and performing much more in-line with each other. The improvement in the performance of the investment-grade segment would appear to us to be more reflective of the current economic environment where a slowdown should improve the attractiveness of higher quality companies.
Convertible Returns (as of 10/31/07)
Source: Merrill Lynch Convertible Research
As you can see from the chart below, the convertible market continues to provide good opportunities to invest in both investment-grade and below investment-grade companies. From a positioning perspective we continue to have a higher-quality bias within our convertible portfolios.
Credit Quality (as of 10/31/07)
Source: Merrill Lynch Convertible Research
Sector Performance
Cyclical energy and materials companies have led the way in gains this year in the global convertibles market. However, leadership is changing to favor growth companies over value companies and to favor less leveraged businesses with less cyclical cash-flow streams. Given the current economic backdrop and our outlook, we believe that energy and materials companies may be vulnerable to a downturn. We have emphasized noneconomically sensitive sectors over the past two years, particularly mid-size and larger growth companies that we believe can generate internal cash flows to sustain their growth. We do not believe it appropriate to increase our risk posture; and most likely we will continue to migrate to investments with lower business and credit risks.
Global Convertible Returns (2007 through September 30, 2007)
Source: Merrill Lynch Convertible Research, Global 300 Index
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, "Convertible New Issue Survey," 11/1/2007
3Merrill Lynch Convertible Research
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 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. The Merrill Lynch Global 300 Index is a global convertible index composed of companies representative of the market structure of countries in North America, Europe, and the Asia/Pacific Region. The stock market is represented by the S&P 500 Stock Index, generally considered representative of the U.S. large-cap stock market.
Indices are not managed and one cannot invest directly in an index. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect fees, expenses or sales charges.
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.
The opinions presented are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained here have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed.
Calamos Advisors LLC
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