EQUITY RESEARCH
Equity Linked Strategies | Convertibles Research | May 14, 2009
CONVERTIBLES The CWB Convertible ETF Summary Recently, the first convertible ETF was launched - the newly launched SPDR Barclays Capital Convertible Bond ETF (Bloomberg Ticker: CWB US Equity). It is offered by State Street Global Advisors with the aim of providing access to the convertible bond market to a broad base of investors. The Fund is designed to track the performance of the Barclays Capital U.S. Convertible $500MM+ Index. It first started trading on April 16 and currently has a market cap of $31 million. In this report we provide an overview of the basic aspects of CWB, including ETF mechanisms regarding purchase and redemption of Creation Units, Fund characteristics and holdings, as well as its performance relative to the Barclays Capital U.S. Convertible $500MM+ Index. We find that based on its net asset value (NAV) returns, since inception, CWB has a correlation of 0.88 with the Barclays Capital U.S. Convertible $500MM+ Index. We also conduct back test based on the current fund holdings over 1 year history and find the hypothetical correlation to be 0.96.
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. Customers of Barclays Capital in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-253-4626 to request a copy of this research. Investors should consider this report as only a single factor in making their investment decision. PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 9.
Venu Krishna, CFA Head of EQ-Linked Strategies +1 212 526 7328
[email protected] BCI, New York Manoj Shivdasani, CFA Convertible Research +1 212 526 5995
[email protected] BCI, New York Peng Cheng Convertible Research +1 212 526 8432
[email protected] BCI, New York
Barclays Capital | Convertibles Research
Introduction The purpose of this report is to provide an overview of the newly launched SPDR Barclays Capital Convertible Bond ETF (Bloomberg Ticker: CWB US Equity). It is offered by State Street Global Advisors with the aim of providing access to the convertible bond market to a broad base of investors. The Fund is designed to track the performance of the Barclays Capital U.S. Convertible $500MM+ Index. It first started trading on April 16 and currently has a market cap of $31 million.
Barclays Capital U.S. Convertible Indices Launched in January 2003, the Barclays Capital U.S. Convertible Indices are designed to provide investors with a comprehensive, unbiased performance tool to assist them in portfolio management and benchmarking goals, and relevant statistics regarding the convertible universe. The Barclays Capital U.S. Convertible $500MM+ Index is a member of the U.S. Convertible Indices and includes securities that fit the following criteria: 1.
Minimum of $500 million size outstanding (or accreted face value for Zeros/OID)
2.
Non-called, non-defaulted securities
3.
At least 31 days until maturity, and
4.
U.S. dollar denominated 144A or Registered convertible tranches.
At any point in time, the Barclays Capital U.S. Convertible $500MM+ Index contains two separate universes of data: Returns and Statistics. The returns universe is set at the beginning of each month and remains static for the entire month. If a security falls out of the Barclays Capital U.S. Convertible $500MM+ Index during the month (falls below minimum size outstanding, defaults, is called, etc.), it will still contribute to returns for the existing month but will be absent from the following month’s returns. On the other hand, the statistics universe is based on a dynamic set of securities that change according to index criteria. If a security fails to meet the minimum index criteria, it will drop out of the statistics universe (but will still contribute to end of month returns data). Also, securities that meet the minimum index criteria, including new issues, may enter the Statistics universe during the month but will not contribute to returns for that month. Therefore, the number of securities comprising the statistics universe will often differ slightly from the returns universe. As of 05/12/2009, the Barclays Capital U.S. Convertible $500MM+ Index contains 134 issues and all four major classes of convertible securities (i.e. cash pay bonds, zeros/OIDs, preferreds and mandatories) with a market value of around $110B. Index data is updated on a daily basis. All returns are market value weighted. Total return will be the sum of price return plus coupon return. Year to date, the Barclays Capital U.S. Convertible $500MM+ Index has delivered a total return of 16.75% compared with the S&P 500 YTD total return of 1.57%. Figure 1 and 2 below show the proportion of Barclays Capital U.S. Convertible $500MM+ Index relative to the Barclays Capital U.S. Convertible Composite Index (a proxy for the whole U.S. convert market). The securities in the Barclays Capital U.S. Convertible $500MM+ Index represent 20% of the Composite Index in terms of number of securities, but 54% in May 13, 2009
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Barclays Capital | Convertibles Research
terms of market value. Figure 3 demonstrates the strong performance of many outright funds YTD, as well as Barclays Capital U.S. Convertible Composite and $500MM+ Indices.
Figure 1: Barclays Capital 500M+ U.S. Convertible Index Securities vs. Composite Index
Cash Pay Mandatories Preferreds Zero/OID Total
Barclays Capital U.S. Convertible Composite Securities 554 23 78 27 682
Barclays Capital U.S. Convertible 500M+ Securities 94 13 23 3 133
500M+ as % of Composite 17% 57% 29% 11% 20%
Source: Barclays Capital
Figure 2: Barclays Capital 500M+ U.S. Convertible Index Market Value vs. Composite Index
Cash Pay Mandatories Preferreds Zero/OID Total
Barclays Capital U.S. Convertible Composite Values 156.49 11.94 25.69 6.62 200.74
Barclays Capital U.S. Convertible 500M+ Values 79.324 10.025 18.023 2.01 109.382
500M+ as % of Composite 51% 84% 70% 30% 54%
Source: Barclays Capital
Figure 3: Outright Convert Funds Top Performers % Returns YTD (Assets at least $200M)
Ticker Name FCVSX Fidelity Convertible Secs PCONX Putnam Convrt Inc Grw Trst RPFCX Davis App & Income Fund FISCX Franklin Convertible Sec MCOAX Mainstay Convertible Fund VCVSX Vanguard Convertible Sec-Inv ACHBX Van Kampen Harbor Fund CCVIX Calamos Convertible Fund PACIX Columbia Conv Securities RCVAX Oppenheimer Convert Secs Barclays Capital U.S. Convertible Composite Barclays Capital U.S. Convertible 500M+
YTD % 21.8 19.5 17.4 15.8 14.5 14.5 13.0 12.3 11.9 11.6 15.7 16.8
Assets ($M) 1,586 513 363 525 346 1,308 228 1,438 405 263 200,738 109,393
Source: Barclays Capital, Bloomberg
A link to the Barclays Capital U.S. Convertible $500MM+ Index can be found on Barclays Capital Live by selecting the Equities tab, then “Convertible Bonds”, and then “U.S. Convert Index”. Alternatively, it may be accessed by selecting the Indices tab, then “Benchmark Indices”, followed by “U.S. Convertibles”.
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Barclays Capital | Convertibles Research
CWB Convert ETF Mechanisms Outstanding shares of an ETF can be traded freely on the exchange. However, creating new shares requires dealing in Creation Units. Each Creation Unit is a large specified number of ETF shares. In the case of CWB, it is 200,000 shares. The mechanism of purchasing and redeeming Creation Units has an important feature which distinguishes it from buying and selling existing ETF shares. That is, the mechanism is often times an in-kind exchange, although cash settlement is also possible. In addition, the purchase and redemption are transacted through “Authorized Participants”, i.e. market makers of the Fund. In other words, to create (i.e. purchase) Creation Units, the investor must deliver to the Authorized Participants a specified portfolio of securities, instead of cash. The content of the portfolio is at the discretion of the Fund and need not be similar to the Fund holdings. For CWB, it should be a substantial replication of the Fund holdings, according to the Prospectus. In order to redeem, the investor can aggregate ETF shares into Creation Units, then exchange for the portfolio of underlying securities. The underlying securities of the Creation Units are published daily to the Authorized Participants before market open.
Figure 4: ETF Redemption and Creation Mechanisms
Redemption
Creation
Investor B
Underlyings
Investor A
Creation Units
Authorized Participant B
Underlyings
Authorized Participant A
CWB Publish Underlying Securities of Creation Units Source : Barclays Capital
Since the Net Asset Value (NAV) of the Fund is determined daily, and the creation and redemption can occur as frequently, any large discount or premium of the fund value and NAV should not be sustained, otherwise arbitrage is possible. If the ETF price is higher than the NAV, one can buy the underlying securities, deposit them in exchange for the Creation Units, then sell the ETF shares in the open market. On the other hand, if the ETF price is lower, one can buy the ETF shares, aggregate them into Creation Units, redeem them for May 13, 2009
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Barclays Capital | Convertibles Research
underlying securities, and sell the underlying securities at NAV. In practice, however, the liquidity of the underlying securities may also cause some differences in the NAV and ETF price to persist.
SPDR Barclays Capital Convertible Bond ETF The ETF (Bloomberg Ticker: CWB US Equity) was launched in April 2009 by State Street Global Advisors. According to the Prospectus, the Fund seeks a correlation of 0.95 or better between the Fund’s performance and the Barclays Capital U.S. Convertible $500MM+ Index. The Fund uses a sampling method. Therefore, it does not own all securities in the Barclays Capital U.S. Convertible $500MM+ Index, but rather selects a number of representative bonds. Figure 5 shows the % holdings as of 04/20/2009. The portfolio consisted of 38 securities or about 29% of the total securities in the Barclays Capital U.S. Convertible $500MM+ Index. However, they represent about 44% of the market value of the universe. Figures 2 and 3 break down the percentages by security types. We believe it is reasonable to expect that as the size of the Fund grows, the holdings will also expand going forward. The Fund also provided breakdown by quality and maturity. See Figures 6 and 7 for the information and comparison with the Barclays Capital U.S. Convertible $500MM+ Index. As the figures show, the Fund closely matches both the credit quality and maturity of the Barclays Capital U.S. Convertible $500MM+ Index. The goal of the Fund is to mirror as closely as possible the total return of the returns universe (recall differences may exist between returns and statistics universe of the Barclays Capital U.S. Convertible $500MM+ Index). As per our understanding, adjustments to the portfolio will be made throughout the month as needed, given cash uses/needs, trading liquidity, and other factors. Since the Barclays Capital U.S. Convertible $500MM+ Index returns universe is rebalanced every month, we believe it is reasonable to expect the Fund to rebalance at least monthly. Further information and fund literature can be found on the SPDR website http://www.spdrs.com.
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Barclays Capital | Convertibles Research
Figure 5: Fund Holdings (as of 04/20/2009) Issuer EMC Transocean Amgen Bank of America Prudential Nabors Vornado Mylan Medtronics Cephalon Archer Daniels Liberty Media Prologis Wells Fargo Hologic Newmont Mining Teva Symantec Qwest Communications Nextel Communications Peabody Energy Intel Gilead Sciences Microchip Virgin Media Watson Pharmaceuticals Freeport-McMoran Micron Technology AMD Intl Game Technology Chesapeake Energy Sandisk Alliance Data Systems Massey Energy L-3 Comms Citigroup Linear Technology Boston Properties Cash Total Net Asset
Ticker EMC RIG AMGN BAC PRU NBR VNO MYL MDT CEPH ADM TWX PLD WFC HOLX NEM TEVA SYMC Q S BTU INTC GILD MCHP VMED WPI FCX MU AMD IGT CHK SNDK ADS MEE LLL C LLTC BXP
Coupon 1.750 1.500 0.125 7.250 0.000 0.940 2.850 6.500 1.625 2.000 0.875 3.125 2.250 7.500 2.000 1.250 1.750 0.750 3.500 5.250 4.750 2.950 0.625 2.125 6.500 1.750 6.750 1.875 6.000 2.600 2.500 1.000 1.750 3.250 3.000 6.500 3.000 2.875
Maturity 12/01/2013 12/15/2037 02/01/2011 Perpetual 12/15/2037 05/15/2011 04/01/2027 11/15/2010 04/15/2013 06/01/2015 02/15/2014 03/30/2023 04/01/2037 Perpetual 12/15/2037 07/15/2014 02/01/2026 06/15/2011 11/15/2025 01/15/2010 12/15/2041 12/15/2035 05/01/2013 12/15/2037 11/15/2016 03/15/2023 05/01/2010 06/01/2014 05/01/2015 12/15/2036 05/15/2037 05/15/2013 08/01/2013 08/01/2015 08/01/2035 Perpetual 05/01/2027 02/15/2037
Weight % 6.10 5.60 5.46 5.12 4.54 4.17 4.10 3.94 3.77 3.68 3.48 3.40 3.40 3.26 2.99 2.80 2.73 2.66 2.61 2.51 2.43 2.19 2.08 1.98 1.86 1.83 1.76 1.48 1.46 1.44 1.28 1.05 0.97 0.94 0.84 0.72 0.71 0.53 -1.86
Market Value $725,759 666,679 649,444 609,125 539,955 495,864 488,474 469,255 448,885 438,473 414,186 405,311 404,250 388,232 356,000 332,890 325,174 316,928 311,259 298,222 289,530 260,348 247,710 235,871 221,477 218,385 209,640 176,188 173,333 171,782 152,413 124,869 115,678 111,516 99,547 85,625 84,408 62,639 -221,144 $11,904,180
Source: State Street Global Advisors
Figure 6: CWB Securities vs. Barclays Capital $500M+ U.S. Convertible Index
Cash Pay Mandatories Preferreds Zero/OID Total
Barclays Capital U.S. Convertible Securities as $500MM+ Index % of Index CWB Securities Total Securities 94 71% 33 13 10% 2 23 17% 3 3 2% 0 133 100% 38
Source: Barclays Capital, State Street Global Advisors
May 13, 2009
Securities as % of CWB Total 87% 5% 8% 0% 100%
CWB as % of Index 35% 15% 13% 0% 29%
Figure 7: CWB Market Value vs. Barclays Capital $500M+ U.S. Convertible Index
Cash Pay Mandatories Preferreds Zero/OID Total
Barclays Capital U.S. Convertible Value as % $500MM+ Index of Index Value ($M) Total 78,428 75% 10,380 10% 14,206 14% 1,948 2% 104,961 100%
CWB Value ($M) 35,464 3,760 7,366 0 46,590
Value as % of CWB Total 76% 8% 16% 0% 100%
CWB as % of Index 45% 36% 52% 0% 44%
Source: Barclays Capital, State Street Global Advisors
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Barclays Capital | Convertibles Research
Figure 8: Quality Breakdown
Quality Aaa A Baa Below Baa Not Rated
Figure 9: Maturity Breakdown
Barclays Capital U.S. Convertible $500MM+ Index 0% 21% 28% 37% 15%
CWB 1% 22% 28% 38% 12%
Source: Barclays Capital, State Street Global Advisors
Maturity 0-1 1-2 2-3 3-5 5-7 7 - 10 10 - 15 15 - 20 20 - 30 30+
Barclays Capital U.S. Convertible $500MM+ Index 1% 13% 10% 18% 4% 1% 6% 10% 25% 12%
CWB 2% 11% 7% 18% 10% 2% 5% 10% 24% 11%
Source: Barclays Capital, State Street Global Advisors
The Fund currently has a market cap of $31 million. The size of the Fund has grown rapidly, driven primarily by the increase in shares outstanding. There are 1,000,000 shares outstanding as of 05/12/2009, compared to the 200,000 shares at inception.
Figure 10: Price and Shares Outstanding
31
1000
6.0%
900
5.0%
800 700
30.5
600 30 29.5
4.0% 3.0%
500
2.0%
400
1.0%
300
0.0%
200
29
100 0
28.5 4/16 4/20 4/22 4/24 4/28 4/30 5/4 5/6 5/8 5/12 Shares Out (x000)
Source: Bloomberg
CWB NAV
-1.0%
4/16 4/17 4/20 4/21 4/22 4/23 4/24 4/27 4/28 4/29 4/30 5/1 5/4 5/5 5/6 5/7 5/8 5/11 5/12
31.5
Figure 11: Cumulative Returns Since Inception
-2.0% -3.0% CWB NAV
Index
Tracking Error
Source: Barclays Capital, Bloomberg
The performance of the Fund can be evaluated against its stated objective of achieving a correlation of at least 0.95 with the Barclays Capital U.S. Convertible $500MM+ Index. We look at the NAV of the Fund instead of the price, since the price may be subject to market conditions outside of the Fund’s control. Based on the 18 daily return data points since inception, the correlation of the Fund NAV and the Barclays Capital U.S. Convertible $500MM+ Index is about 0.88.
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Barclays Capital | Convertibles Research
Figure 12: Fund NAV Daily Returns vs. Index Returns Since Inception 2.00 1.50
NAV Returns (%)
1.00 0.50 0.00
-4
-3
-2
-1
-0.50 0
1
2
-1.00 -1.50 -2.00 -2.50 Index Returns (%)
Source: Barclays Capital, Bloomberg
The existing time series is not sufficiently long to accurately measure the correlation. Still, we can rely on historical data for back testing purposes, subject to some simplifying assumptions. We assume that we initiated a portfolio with the same members and weighting as Figure 5 a year before inception (04/16/2008). Assuming the portfolio was static for one year with no rebalancing, the correlation of daily returns turns out to be 0.96, as Figure 13 shows. Interestingly, even if only the top 10 holdings were taken to the back test, the correlation still comes out to be about 0.90. We believe the estimate is conservative because the portfolio was completely indifferent to index changes and movements. If the portfolio was actively managed, as in the case of the Fund, we would expect the correlation to be at least as high. Nonetheless, results from back testing may not accurately predict future performance.
Figure 13: Back Test Fund Returns vs. Index Returns 6
4
NAV Returns (%)
2
-8
0 -6
-4
-2
0
2
4
6
-2
-4
-6
-8 Index Returns (%)
Source: Barclays Capital
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Analyst Certification: We, Venu Krishna and Manoj Shivdasani, 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 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 communication as only a single factor in making their investment decision. The analysts responsible for preparing this report have received compensation based upon various factors including the Firm's total revenues, a portion of which is generated by investment banking activities. For current important disclosures 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 the firm's disclosure website at www.lehman.com/disclosures. On September 20, 2008, Barclays Capital acquired Lehman Brothers' North American investment banking, capital markets, and private investment management businesses. We have endeavored to provide conflicts of interest disclosures on a combined basis. All ratings and price targets prior to the acquisition date relate to coverage under Lehman Brothers Inc. The convertible valuations are based on Barclays Capital Inc's proprietary convertible valuation model, under which key assumptions relate to credit spread and volatility 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% 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. Please note that the convertible recommendations in this report may not correlate to the fundamental ratings applied to the stocks by Barclays Capital equity research analysts. Guide to Barclays Capital Fundamental Equity Research Rating System Our coverage analysts use a relative rating system in which they rate stocks as 1‐Overweight, 2‐ Equal weight or 3‐Underweight (see definitions below) relative to other companies covered by the analyst or a team of analysts that are deemed to be in the same industry sector (“the sector coverage universe”). To see a list of companies that comprise a particular sector coverage universe, please go to www.lehman.com/disclosures. In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1‐Positive, 2‐Neutral or 3‐Negative (see definitions below). A rating system using terms such as buy, hold and sell is not the equivalent of our rating system. Investors should carefully read the entire research report including the definitions of all ratings and not infer its contents from ratings alone. Stock Rating 1‐Overweight ‐ The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12‐month investment horizon. 2‐Equal weight ‐ The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12‐month investment horizon. 3‐Underweight ‐ The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12‐month investment horizon. RS‐Rating Suspended ‐ The rating and target price have been suspended temporarily due to market events that made coverage impracticable or to comply with applicable regulations and/or firm policies in certain circumstances including when Barclays Capital is acting in an advisory capacity in a merger or strategic transaction involving the company. Sector View 1‐Positive ‐ sector coverage universe fundamentals are improving. 2‐Neutral ‐ sector coverage universe fundamentals are steady, neither improving nor deteriorating. 3‐Negative ‐ sector coverage universe fundamentals are deteriorating. Distribution of Ratings: Barclays Capital Equity Research has 1203 companies under coverage. 36% have been assigned a 1‐Overweight rating which, for purposes of mandatory disclosures, is classified as a Buy rating, 38% of companies with this rating are investment banking clients of the Firm. 47% have been assigned a 2‐Equal weight rating which, for purposes of mandatory disclosures,is classified as a Hold rating, 31% of companies with this rating are investment banking clients of the Firm. 14% have been assigned a 3‐Underweight rating which, for purposes of mandatory disclosures, is classified as a Sell rating, 23% of companies with this rating are investment banking clients of the Firm. May 14, 2009
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