Historical Perspective of Rate Cuts

8/3/2019 Historical Perspective of Rate Cuts

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Comment MORGAN STANLEY DEAN WITTER

Please refer to important disclosures at the end of this report.

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Strategy

Equity Research

North America

Market Commentary/Strategy January 11, 2001Anand S. Iyer, CFA+1 (1)212 761 [email protected]

Historical Perspective of Rate Cuts

• Historical Perspective of Fed Rate Cuts

The history of rate cuts has consistently led to a rise in the convertible

market

• Since 1985, There Have Been 7 Rate Cuts

Cuts occurred in 1998, ’96 ’92 ’91, ’89, ’86 and ’85 - during whichtime the convertible market rose an average of 21%.

• In 1991, When Rates Were Cut from 7.00% to 4.00%, The Convertib le market

Rose by 32.9%, and in 1992, When Rates Were cut by 100 bps, The

Convertible Market Rose by 18.3%

Although 2001 may not exactly replicate 1991-1992, we think areduction in rates of a 200 basis point magnitude could result in a 15-20% convertible market return in 2001.

U.S. Convertible Research



MORGAN STANLEY DEAN WITTER

U.S. Convertible Research – January 11, 2001


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Historical Perspective of Rate Cuts

Over the Past Month We Have Made Several Changes inthe MSDW Convertible Recommended Portfolio.

As we expect overall earnings to be slower, and short rates

to continue to decline, our strategy is to select those

convertibles which offer:

1. High yield-to-maturity, where earnings growth

prospects should occur later in 2001

2. Those interest rate sensitive sector convertibles which

would benefit from a decline in interest rates.

3.

Some value convertibles from telecom sector whichsuffered greatly in the year 2000.

Therefore, our recommendations are:

High Yield Convertibles:

• NVIDIA (NVDA) 4.75% Convertible SubordinatedNotes due 2007

• International Rectifier (IRF) 4.25% ConvertibleSubordinated Notes due 2007

• Excite@Home (ATHM) 0.525% (OID) ConvertibleSubordinated Debentures due 2018

• Aether Systems (AETH) 6.00% Convertible

Subordinated Notes due 2005

Rate Cut Beneficiaries:

• Fifth Third Bancorp (FITB) $1.50 Trust ConvertiblePreferred Stock due 2028

• ACE Limited (ACL) $4.125 PEPS due 2003

• Providian Financial (PVN) 3.25% ConvertibleSubordinated Notes due 2005

Telecom:

• TCI Pacific/TCOMA (T) $5.00 ConvertiblePreferred due 2006

• Global Crossing (GX) $16.875 (6.75%) ConvertiblePreferred Stock due 2012

Exhibit 1

Interest Rate Changes and Convertible Market Performance, 1985 - 2000 (Rate Cut Years in Bold)

Total ReturnConvertible NASDAQ

Fed’s Rate Action Commentary Market Composite

Current 6.00% Federal Reserve is expected to continue to cut rates.

2000 5.50% 6.50% Rate increases on 2/2 & 3/21 followed by 50 bps hike on 5/16 -18.01% -40.09%

1999 4.75% 5.50% Three rate hikes are mitigated by Y2K liquidity 41.47% 84.83%

1998 5.50% 4.75% 18 months of rate stability followed by three late-year cuts 6.67% 39.21%

1997 5.25% 5.50% One rate hike followed by a long period of stable rates 18.40% 23.14%

1996 5.50% 5.25% One early rate cut on 1/31 followed by a stable rate trend 15.06% 21.95%

1995 5.5% 6.0% 5.5% Rate rises 50 bps to 6.00% on 2/1 followed by 2 rate cuts 24.74% 42.58%1994 3.00% 5.50% Series of six rate hikes from 2/4 through 11/15 -4.71% -2.43%

1993 Stable @ 3.00% Rate is constant for 17 months 19.47% 15.63%

1992 4.00% 3.00% Three rate cuts totaling 100 bps occur in 2-3 mo. intervals 18.34% 15.43%

1991 7.00% 4.00% Ten rapid rate cuts totaling 300 bps occur by year-end 32.85% 57.54%

1990 8.25% 7.00% Four late-year rate cuts total 125 basis points -6.40% -18.61%

1989 9.00% 8.25% Five early-year rate hikes are followed by six rate cuts 13.80% 20.14%






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Exhibit 2

Interest Rate Changes and Convertible Market Performance, 1985 - 2000 (Rate Cut Years in Bold)Column Headings

1988 6.83% 8.69% Ten incremental rate hikes negate easing early in the year. 13.30% 12.67%

1987 6.00% 6.83% Rates increase via five rate hikes despite two inter-year cuts -5.90% -6.45%

1986 7.75% 5.875% Four rate cuts result in 187.5 bps easing 14.53% 7.34%.

1985 8.125% 7.75% Moderate 37.5 bps easing resulting from 13 rate decisions 26.26% 32.25%

Notes: The years indicated in Bold are those years in which Federal Reserve interest rate cuts relate to positive equity and convertible market performance

Sources: Federal Reserve Data and Morgan Stanley Dean Witter

NVIDIA (NVDA) 4.75% Convertible SubordinatedNotes due 2007 - (Convertible Price: 75%, stock price:$44.3125). With a 6.3% current yield and a 9.9% yieldto its 2007 maturity, the NVDA 4.75% convertible notes

suggest a solid degree of defensiveness relative to thecommon stock, in our view. Using a volatility of 55%,which is about 66% of the company’s long term calloption volatility, and a 700 basis point spread, producesa theoretical valuation of 80%, suggesting the security is13% undervalued based on its current price. In addition,Mark Edelstone believes Strong Buy rated NVDA isenjoying strong market share gains in the desktop PCmarket, combined with the opportunity to enjoyadditional revenue streams from new products in thenext 6 to 9 months.

International Rectifier (IRF) 4.25% ConvertibleSubordinated Notes due 2007 - (Convertible Price:75.125%, stock price: $36.8125). At current levels, wefavor the convertible for yield-oriented investors as thesecurity offers a 5.7% current yield and a 9.6% yield toits July 15, 2007 maturity. Its 53% conversion premiumand 50% delta suggest moderate participation in theunderlying common, while its 2.4% premium overinvestment value points to a solid level of defensivenessas long as credit spreads remain at recent levels. Mark Edelstone believes IRF will meet operating expectationsfor the December quarter and that continued solidexecution should enable growth in the March quarter.Currently trading at C2001 PEG of 0.3x and 10xearnings, IRF looks to be undervalued.

Excite@Home (ATHM) 0.525% (OID) ConvertibleSubordinated Debentures due 2018 - (ConvertiblePrice: 37.00%, stock price: $7.00). We view the ATHM0.525% (OID) convertible bond as a credit sensitivechoice. The convertible offers a 1.4% current yield but a19.0% yield-to-put in less than three years. The issue istrading at an implied credit spread of 1,828 basis pointswhich implies a 10% premium to investment value.

Aether Systems (AETH) 6.00% ConvertibleSubordinated Notes due 2005 - (Convertible Price:59.50%, stock price: $37.4375). We continue view theAETH convertible as a defensive means of stayinginvolved in the enterprise wireless systems space and as

appropriate for credit sensitive investors. The issuecurrently offers an 10.9% current yield and an equity-like 21.2% yield to its 3/05 maturity, a relatively soundthesis, considering the company’s cushion of over $1billion of cash. The company’s $27 per share of cashnow represents over 75% of AETH’s common stock price.

Given our expectation of continued rate cuts, we havealso modified the MSDW Recommended Convertible

Portfolio by adding interest sensitive securities,specifically those from the financials group, as it couldaugur a more favorable investment climate for thesector. Our three recent additions to the MSDW

Convertible Recommended Portfolio in the financialsector includes:

Fifth Third Bancorp (FITB) $1.50 Trust ConvertiblePreferred Stock due 2028 - (Convertible Price:$37.6875, stock price: $59.9375). We view the FITB asattractive as it offers a reasonable 3.97% current yieldand high 94% delta with which to participate in thecommon and offers an opportunity for conservativeinvestors due to its Aa3/A investment grade rating. Wenote that Diane Merdian raised her investment rating onFITB common stock to Outperform from Neutral lastNovember on the heels of the company’s announced

$4.9 billion acquisition of Old Kent Financial.

ACE Limited (ACL) $4.125 PEPS due 2003 -(Convertible Price: $76.4375, stock price: $36.375). Weview the ACL $4.125 PEPS as an equity substitute givenits high delta and low conversion premium. ThisA2/BBB rated issue offers a 5.4% current yield (a 384basis point advantage to the common), and trades with a75% delta and 10% conversion premium. AliceSchroeder upgraded ACE common from Outperform to






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Strong Buy last week with 34% upside on the commonto her new target of $50.

Providian Financial (PVN) 3.25% Convertible

Subordinated Notes due 2005 - (Convertible Price:99.125%, stock price: $54.4375). The issue offers a3.6% current yield (a 279 basis point advantage over thecommon), a 3.13% yield to the 8/15/05 maturity and has2.61 years of call protection. Using a 400 basis pointcredit spread and a 45% stock volatility, we think thisissue is currently 4% undervalued.

As far as the telecom sector is concerned, we favor thisgroup since we believe that a return of confidence in thetelecom sector and availability of funds to companieswithin the sector could mean that concerns about lack-of-funding - especially among larger, more established

companies - would begin to dissipate.

TCI Pacific/TCOMA (T) $5.00 Convertible Preferreddue 2006 - (Convertible Price: $150.625, stock price:$23.125). We especially favor AT&T and added thissecurity to The Portfolio on 12/26/00, thinking thatAT&T’s announced quarterly reduction on 12/20/2000to $0.15 from $0.88 on an annual basis has sharplyimproved the valuation of the TCI Pacific/TCOMA$5.00 convertible preferred stock (exchangeable intoshares of AT&T) for large cap value investors. We alsoview the security attractive for its upside/downsideparticipation of 83%/40% in the common until its call

date of 8/15/01. We believe both equity-sensitive anddefensive value investors would find this investmentgrade (Baa2/BBB+) convertible preferred stock attractive. We add that Simon Flannery upgraded T

common stock to Strong Buy from Neutral yesterdaynoting that the company’s upcoming four-way break upshould help unlock substantial value for shareholders.

Global Crossing (GX) $16.875 (6.75%) ConvertiblePreferred Stock due 2012 - (Convertible Price:$194.500, stock price: $22.625). We view all three of theGX convertible issues as attractive middle-of-the-roadchoices given their balance of upside potentialparticipation and high current income. However, weprefer the GX $16.875 (6.75%) security as it offers a8.8% current yield, a 10.3% yield to stated maturity, andreasonable equity participation with a 66% delta, and thelongest call protection of the three securities at 4.26years. The security has added takeover protection in thecase of a cash merger.

Finally, we also like Union Pacific as a large cap valueplay:

Union Pacific (UNP) $3.125 Convertible PreferredStock due 2028 - (Convertible Price: $49.00, stock price: $53.188). In our view, the UNP $3.125convertible preferred is appropriate as a way of participating in the favorable energy trends that are acomponent of our investment thesis. The Ba2/'BB+ ratedpreferred offers a 6.4% current yield (a 486 basis pointpick-up over the common) with a 47% delta thatsuggests moderate participation in the common. Webelieve the full valuation of this security, and relatively

high volatility, are due in large part to the practicalconsiderations of the company's investment merits. It isan asset-rich company with a solid credit profile and aclassic "old economy" safe haven.




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© 2001 Morgan Stanley Dean Witter

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Historical Perspective of Rate Cuts