EQUITY LINKED STRATEGIES | CONVERTIBLES RESEARCH January 06, 2012 V Kih CFA US Convertibles Outlook 2012 Venu Krishna, CFA +1 212 526 7328 [email protected]Manoj Shivdasani, CFA Dusting off from a Stumble +1 212 526 5995 [email protected]Piyush Anchliya +1 212 526 8432 [email protected]Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 46
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EQUITY LINKED STRATEGIES | CONVERTIBLES RESEARCH January 06, 2012
Barclays Capital does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report.Investors should consider this report as only a single factor in making their investment decision.PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 46
Agenda
• Performance • Primary Market Outlook2011
• Technicals Recap
• Economic Outlook • Equity Outlook
MACRO OUTLOOK• Credit Outlook • Volatility Outlook
Widening Spreads and Idiosyncratic Equity Declines Affected Convert Performance
Rates Excess ReturnSpread and Rates Excess Return
Although a rally in rates drove credit market returns, it contributed little to convert performance
Credit spread widening was a headwind in the convert market and Convert marketCredit spread widening was a headwind in the convert market and Convert market cheapened relative to straight debt market
Idiosyncratic risk negatively impacted overall index returns (MF Global, Cemex, Ford, GM American Airlines Citigroup Solar sector)
January 6, 20127
GM, American Airlines, Citigroup, Solar sector)
Yet Long Term Risk-Adjusted Returns Remain Competitive
Primary Market Outlook: Lacking a Catalyst, For Now
Lackluster primary issuance in the last three years due to
Low interest rates
No Near-Term Catalyst for Ramp-Up in New Issuance
Low interest rates
Deleveraging by corporations; Lack of demand for growth/restructuring capital in the current environment
D it i ifi t t d d f th t l d ’t t l t fDespite significant pent-up demand for the asset class, we don’t see a catalyst for ramp-up in new issuance in the near-term as
High equity risk premiums remain high; Low rates environment likely to persist
Liquidity held up through the various market gyrations this year
Average monthly TRACE volumes were $24 1bn for 2011Average monthly TRACE volumes were $24.1bn for 2011
That said, market did witness choppiness and subdued volumes during intermittent periods
Sharp decline in liquidity in corporate bond markets and increased regulatory uncertainty facing broker dealers suggests that liquidity will remain a key concern for investors; Lack of supply puts additional pressure
January 6, 201216
Source: Barclays Capital.
TRACE data as of November 2011
Macro Backdrop 2012
Economic Outlook: Moderate Growth but Risks RemainBaseline Forecast: 2.5% GDP growth; 8% unemployment rate by the end of 2012
EU debt crisis major risk to outlook with non-extension of payroll tax cut key domestic riskrisk
Inflationary Pressures Building Up – Core inflation likely to reach 2.5% by the end of 2012
Yet if financial conditions deteriorate sharply, the Fed may embark upon another round of QE
Source: Barclays Capital.
Unemployment falling faster than in last cycleUS Consumer Spending Picking Up
Risk Aversion faded to a certain extent in December in the US
But equities retained some of their defensive biaswith health care and staples being the best performers Risk Assets Outperformed in December
Abs Returns6%
1M Returns
1.0%
1.5%
2.0%
2.5%
3.0%
-4%
-2%
0%
2%
4%
6%
-0.5%
0.0%
0.5%
LQD* JNK* DXY CWB PFF* TLT* CRY
Last 1M
-10%
-8%
-6%
XLV XLP XLY XLF XLI XLK XLU XLE XME
Absolute Beta Adjusted
Equity indices globally had positive absolute returns ..and precious metals underperformed
6%Returns
10%
Abs Returns
-6%
-4%
-2%
0%
2%
4%
-10%
-5%
0%
5%
Source: Bloomberg, Barclays CapitalNote: Start date for return calculations is Nov 23rd * TLT: Treasury Bond ETF; LQD: IG Corporate Bond ETF; PFF: Preferred Stock ETF;JNK HY Corporate Bond ETF; CWB:Convertible Bond ETF
-10%
-8%
6%
.HSI. SPX RTY SX5E EEMAbsolute Beta Adjusted
-15%Agri Brent Oil Industrial Metals Gold Silver
Last 1M
21
TLT: Treasury Bond ETF; LQD: IG Corporate Bond ETF; PFF: Preferred Stock ETF;JNK HY Corporate Bond ETF; CWB:Convertible Bond ETF
January 6, 2012
Equity Outlook: ‘Muddle Through’ 2012 with Difficult 1H122012 Year End S&P Target of 1330 based on 12.9x multiple on ‘12E Earnings of $103
Risks to the range of economic outlook are asymmetric with few prospects of acceleration but significant downside risksacceleration but significant downside risks
S&P multiple to remain low at 12.9x given y/y earnings growth deceleration & heightened uncertainty surrounding public and financial sector deleveraging
Range-bound market despite optically attractive valuation; 1H likely to remain challenging but equities should fare better in second half as EU crisis fallout dissipates
Recommend scaling back aggressive sector exposure in anticipation of a difficult 1H12
Equity valuations relative to Fixed Income appear compelling but the argument might be flawed due to the Fed distorting the interest rate curveg
Moreover, stocks screen only modestly inexpensive under models of economic uncertainty. B/S metrics (price/book, price to sales) and metrics that incorporate debt (EV/EBITDA or EV/Sales) are still not compelling for stocks
Valuation Relative to Fixed Income might be flawed due to Fed distorting the interest rate curve
January 6, 201223
Source: Factset, Barclays Capital.
M&A deal activity declined in 2H11
…and sector distribution was largely unchanged…The level of new M&A deal activity and announced equity value fell in the second half of 2011
100 20Communications
Basic Materials6.2%
Utilities
40
60
80
8
12
16
Communications8.2%
Consumer, Cyclical
0.9%
25.7%
Technology6.4%
0
20
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec0
4
Deal Equity Value ($ bn - left axis) # of Announced Deals (right axis)
Consumer, Non-Cyclical23.4%
Financial10.1%
Industrial10.6%
Energy14.6%
…the median risk arb spread remained relatively steady through the end of 2011
…and breakeven probabilities were in line with historic averages.
Credit Outlook: High YieldBase Case: 5-7% Total Returns & 5-7% excess returns as well
Given an uncertain macro outlook and an expectation of modest increase in interest rates 2012 is likely to another below coupon year for total returnsrates, 2012 is likely to another below coupon year for total returns
Default rate likely to remain low at 2-3% due to lower leverage across most cyclical sectors driven by corporate discipline
Continue to favor high quality due to a) high quality shows resilience in a slow growth environment b) higher quality spreads already price-in more bad news c) no-default loss compensation is more robust for higher quality
Li idit i k i t t t l d li l f t t l
2012 Total Return Scenarios
Liquidity remains a key investor concern: structural and cyclical factors at playSource: Barclays Capital.
US HY Price 94.75 95.5 101 90 68.75Price Return -0.8% 0.0% 5.5% -5.7% -25.2%Default Loss -1.7% -1.7% -1.7% -3.4% -6.9%Coupon Return 8.7% 8.7% 8.7% 8.7% 8.7%Year-end total return 6.1% 6.9% 12.5% -0.5% -23.4%
January 6, 201225
Source: Barclays Capital.
Credit Outlook: Investment GradeBase Case: 4.25% Total Returns and 20 bps spread tightening
1) Base case: EU sovereigns return to a stable path and spreads tighten by 40bps as they start to reflect the underlying fundamentals; however a challenging liquiditythey start to reflect the underlying fundamentals; however, a challenging liquidity environment for bonds and large-scale deleveraging by EU banks will likely persist even if EU stabilizes 2) In a much less probable outcome, a further deterioration of the situation in EU could cause a severe selloff in risky assets.
Operating fundamentals strong by historical standards and estimates for ‘12 reasonable. But capital expenditure, M&A, and share repurchases likely to put upward pressure on aggregate leverage.
Model Forecast SpreadsSource: Barclays Capital.
Non-Financials Financials US Credit Corp CDX.IGp
Current Values 192 353 245 141Modeled Value 187 321 232 141Model/real basis -5 -32 -13 0
Modeled Spreads
S C
Modeled SpreadsBase Case 162 292 205 108Downside Case 484 681 549 295Interim Expected Trading Range 170-221 302-358 214-267 111-156
January 6, 201226
Source: Barclays Capital.
Volatility Outlook: Expect to Remain High
Base Case : Realized Volatility 21% (Stress Case: 29%)
Volatility to stay high over the course of 2012, with developments in Europe being the key driver baseline forecast 21% and stress case 29% (SPX realized volatility)key driver – baseline forecast 21% and stress case 29% (SPX realized volatility)
Concerns about US double dip abated, corporate profitability encouraging and Fed’s support should limit downside. However, US not immune to significant deterioration in EuropeEurope.
SPX short dated skew is trading at pre-crisis July 2011 levels, yet high relative to long-term and pre-2008 averages
…and SPX skew still high vs. long term and pre-08 averagesSPX Term Structure has been quite volatile
Source: Barclays Capital.
201 6
5
10
15
0.40.60.81.01.21.41.6
S CS C
0Dec-09 Jun-10 Dec-10 Jun-11 Dec-11
SPX SX5E HSI VIX
0.00.2
Jun-02 Dec-03 Jun-05 Jan-07 Jul-08 Feb-10 Aug-113M Rolling 12M/3M Term Structure VolatilityMean Term Structure Volatility
January 6, 201227Summary of the views of Barclays Capital Equity Derivative Strategy Team
Call overwriting likely to be a good strategy given the outlook for range-bound markets
Base Case : Realized Volatility 21% (Stress Case: 29%)
g y g gy g g
Realized and Implied correlations remain high on an absolute basis and after adjusting for the higher level of current volatility
Position for outperformance of U S vs European Equities using Put spreads rather
..but its secular increase across assets limits downsideCorrelation elevated relative to volatility
Position for outperformance of U.S. vs. European Equities using Put spreads rather than cash/futures; however not immune to significant deterioration in Europe
40
50
60
70
60%70%80%90%
100%
30%40%50%60%70%80%
Pairwise Correlations
0
10
20
30
10%20%30%40%50%
Dec-01 Dec-04 Dec-07 Dec-103M R l d C 3M I l d C 3M I V l (RHS)
0%10%20%30%
Dec-96 Dec-01 Dec-06 Dec-11Commodities Global Equity IndicesUSD FX crosses US Stocks
3M Realized Corr 3M Implied Corr 3M Imp Vol (RHS) USD FX crosses US Stocks
January 6, 201228Summary of the views of Barclays Capital Equity Derivative Strategy Team
Credit vs. Equity: Relatively Synchronized moves in Credit & Equity Volatility Broke Down in the U.S. Recently
While 12M SPX implied volatility dropped sharply in December, credit spreads tightened modestly
Credit spreads in the U.S. now appear wide relative to equity-implied volatility; HY p pp q y p yspreads widest relative to SPX implied vol since 2008
Positive macro views better expressed via long credit vs selling equity implied vol; on the other hand SPX implied volatility is a cheaper hedge than selling credit
Credit Spreads Wide Relative to Equity Implied Volatility
4
-2
0
2
-6
-4
06 07 08 09 10
S C
BarCap IG OAS vs SPX 12M Wtd Avg IV BarCap HY OAS vs SPX 12M Wtd Avg IV
January 6, 201229
Source: Barclays Capital.
Summary of the views of Barclays Capital Equity Derivative Strategy Team
Convertibles: Modest Expectations for 2012
Signs of Relative Value Beginning to Appear in Non-IG spreads; Aggregate Valuations have Improved
Absolute Spreads have also widenedNon-IGs have cheapened relative to HY
Market composition and price distribution attractive
If macro conditions stabilize corporate actions are likely to
Supportive
If macro conditions stabilize, corporate actions are likely toresume
Corporate actions generally positive but a double edgedsword for arbitrage investors
Corporate Actions Positive
sword for arbitrage investors
Source: Barclays Capital.
January 6, 201234
Expected Returns
Key Macro ForecastsEconomics: 2.5% GDP growth, and continuation of easy monetary policy.
Rates: Fed Funds Rate to remain unchanged The Treasury yield curve is likely toRates: Fed Funds Rate to remain unchanged. The Treasury yield curve is likely toremain unchanged as well, as a result of supportive policy.
C dit IG 4 25% b l t t (20b d ti ht i ) d HY 5% 7% b l tCredit: IG 4.25% absolute return (20bps spread tightening) and HY 5%-7% absolutereturn (2-3% default rate, 20bps spread tightening).
Equity: Expect range-bound S&P 500. The 2012 year-end S&P 500 target of 1330 isbased on an unchanged 12.9x multiple on 2012E earnings of $103 (up 6% from 2011Eearnings of $97).
Volatility: Expect volatility to stay high over the course of 2012, with developments inEurope being the key driver. Baseline and stress case SPX realized volatility for 2012
t d t b b t 21% d 29% (2011 22 5%) ti lexpected to be about 21% and 29% (2011: 22.5%), respectively.
Source: Barclays Capital.
January 6, 201236
Base Case Returns ~ 7% UPSIDE CASE BASE CASE DOWNSIDE CASE
• Complex Structures, Technical supply-demand trends• Cheap Embedded Puts in Deep ITM Converts
Overlooked Situations/Valuation Plays
January 6, 201244
Source: Barclays Capital.
Risks: Macro Front and Center
EU debt crisis & US fiscal concerns remain key issues
EU recession
US fiscal issues and policy uncertainty going into the election year
Macro
Though valuations have cheapened
Performance likely a function of policy actions, economic outlook and associated performance of credit equity andValuations outlook and associated performance of credit, equity and rates
Expect correlations to remain high
Valuations
Liquidity remains a key investor concern: structural and temporary factors at play
Low HF participation, regulations
Liquidity
High volatility, lack of supply
Source: Barclays Capital.
January 6, 201245
Analyst Certifications and Important DisclosuresAnalyst Certification:
We, Manoj Shivdasani and Venu Krishna, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report.
Important Disclosures
For current important disclosures, including, where relevant, price target charts, regarding companies that are the subject of this research report, please send a written request to: Barclays Capital Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to http://publicresearch.barcap.com or call 1-212-526-1072.
The analysts responsible for preparing this research report have received compensation based upon various factors including the firm's total
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Risk Disclosure(s):
The convertible valuations are based on Barclays Capital proprietary convertible valuation model, under which key assumptions relate to credit spread and equity l tilit t i M t i l h i f th i bl h i ifi t i t l ti U id /d id l i t k i t id tivolatility metrics. Material changes in any of these variables can have a significant impact on valuation. Upside/downside analysis takes into consideration
likely future valuation and expected trading patterns, among others. It is based on a total return participation of the convertible relative to a +/‐ 25% (unless otherwise specified) change in the common stock’s price over a one-year investment horizon. A material change in the company’s financial situation can significantly alter this assessment.
Mentioned Stocks:
Wesco International (WCC, 04-Jan-2012, USD 53.87)( , , )
NetApp Inc. (NTAP, 04-Jan-2012, USD 35.64)
SBA Communications (SBAC, 04-Jan-2012, USD 43.16)
Salesforce.com Inc. (CRM, 04-Jan-2012, USD 97.48)
Alliance Data Systems Corp. (ADS, 04-Jan-2012, USD 100.94)
W bMD H lth C (WBMD 04 J 2012 USD 37 97)
46
WebMD Health Corp. (WBMD, 04-Jan-2012, USD 37.97)
January 6, 2012
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