Best or worst of both worlds?
Before embarking on the case for convertible bond investment, let two things first be acknowledged. First, there are very few institutional investors who use convertible bonds at all and even fewer who use them in any kind of systematic manner to enhance overall performance. For the vast majority of institutional investors, the case has yet to be made that convertibles can add value to their portfolio management processes.
Second, we must acknowledge that there is no intrinsic characteristic of convertible bonds which compels them to the attention of sophisticated investors. It is undeniably true to say that a convertible bond offers a balance between the security of a conventional bond and the upside of the underlying equity, but sophisticated institutional investors have an infinite range of financial tools at their disposal, enabling portfolios to be constructed with precisely defined mixtures of bonds and equities. The hybrid nature of convertible bonds is not unique and, as table 1 shows, the size and range of the market is far smaller than the underlying equity and bond markets. Convertible bonds cannot offer a full range of customised solutions for institutional investors. Indeed, far from recognising the hybrid characteristic of convertibles as a virtue, the more common attitude is one of contempt. It is far from unusual to hear institutional investors describe convertibles as ‘the worst of both worlds’, best regarded as an obsolete instrument only surviving through the die-hard attitudes of unsophisticated private clients.
Yet there is a small and growing community of institutional investors who are finding that convertibles are offering a real opportunity to add value to their portfolio management processes. At Jefferies we have been advising over 30 pension funds, of varying sizes, how to exploit the market in a systematic manner, and gradually a track record of performance is illustrating to an ever wider audience the potential which other investors may be overlooking.
The case for convertibles rests on three elements. The first element is the growing body of historic data to document and analyse how the convertible bond market behaves under a variety of conditions. This analysis illustrates systematic out-performance by convertibles over comparable mixtures of equity and bonds and also indicates that there may be systematic reasons for that out-performance to persist.
An understanding of the underlying causes of the under-performance is therefore the second element. It is the market participants and their relative contributions to the price-formation process which provide the reasons why convertible markets behave as they do and why they can be expected to continue to behave in this way. In particular, it explains why the market remains systematically cheap, in the technical sense of offering exposure to the underlying equity and credit markets more cheaply than direct investment. The historic data provides the empirical evidence of how systematic, structural cheapness has manifested itself in systematic, long-term excess returns.
The case for convertibles is thus empirical and value-based, not based purely on their theoretical characteristics. In offering exposure to both equity and bond markets through their hybrid character, convertibles stake their claim to investors’ attention by providing that exposure systematically cheaper than through direct investment.
However the third and final element is the most important. Underlying the excess return is an underlying inefficiency in the pricing of convertibles which is particularly manifest in the relative pricing within the market. This is a market which is not merely under-invested, it also has enormous pricing discrepancies between individual instruments. This provides substantial opportunities for adding value through active management and in practice these overwhelm the case for passive investment convertibles defined by the first two elements.
We represent this through the chart (Figure 1) of the comparative risk-return characteristics of various investment styles. Mixtures of the traditional investments of equity and debt are shown on the lowest line. The point representing a 50% mixture of the traditional assets is marked.
Immediately above this point, at a point representing almost identical risk but superior return, is the risk-return point for convertible bonds demonstrated by the empirical evidence. A passive investment approach to convertibles would aim for this return advantage.
This, however, would be to miss the point because the additional gains to be obtained through an active management approach bring the overall return profile far higher without any increase in risk. So far, as the evidence suggests, the convertible bond market adds around 150 basis points of additional return over a ‘50:50’ portfolio without adding risk but the performance of the typical, properly managed convertible bond portfolio is some 500 basis points better, also without additional risk.
This magnitude of added value is not generally available in the traditional asset classes because the breadth and depth of their investor base is so large that large-scale systematic inefficiencies do not persist. Inefficiencies within the convertible market, however, are of an entirely different scale and persistence because the investor base is so poorly developed. It enables the specialist managers to deliver a level of ‘alpha’ which can transform an entire portfolio, even with relatively small allocations to the instrument.
Institutional investors normally express concern over the limited scale of the convertible universe and the problem it poses in terms of liquidity and opportunity. Convertibles are much less liquid than the underlying equity and bond markets but in two ways this is an advantage. First, it is the main deterrent to investors which permits the convertible market to remain systematically undervalued. Second, it rewards the skills of the specialist manager who knows better how to manage a less liquid environment. In this second feature, however, lies the main reason convertible bonds struggle to achieve credibility among institutional fund managers. It is incorrectly presumed by many institutions that a sufficient degree of equity and bond management expertise provides the requisite convertible bond management expertise. It does not. Convertible bond management is a stand-alone specialisation without which convertible bond performance will be disappointing. In fact, unsystematic, unspecialised management will almost inevitably lead to the derided worst-of-both-worlds performance which has attracted so much criticism.
In terms of overall size the investment opportunity currently could absorb up to $200bn. We reach this figure from an overall market size of $450bn and an investment approach which depends on exploiting relative pricing inefficiencies within the market and thus could only operate effectively through owning less than half the total market. Fortunately, for the moment at least, the scale of institutional investor interest currently amounts to a small fraction of this so there is considerable room for growth for an extended period of time. In any event, even if institutional interest was to grow to $200bn, one can be sure it will stimulate issuance to provide yet more opportunity.
Small markets which provide interesting investment opportunities tend to become big markets and this may be the fate of the convertible market. For the moment, however, convertible markets occupy a quiet corner of the financial world, offering excellent returns to a small but committed group of institutions who see that the opportunity they present is all the more attractive and persistent for being so at odds with conventional wisdom.
Convertible issuers in the US tend to be at the lower end of the range of credit quality. The typical investor has high capital requirements and will also be at such an early stage of development that the owners prefer to restrain dilution and maintain leverage into future growth. Alternative sources of debt financing for such issuers will be few because they are too early in their development cycle to generate sufficient cashflow to make them eligible for high-yield or bank financing.
Sectors that most fit this description are the “new technology” areas of internet, communications and technology. Issuance has been at record levels in recent months, mostly from these types of companies. There is a long tradition in the US for the financing of new technology infrastructure to be assisted by the issuance of convertible bonds. Between 1850 and 1870 the new railway companies were prolific issuers of convertible bonds and in the first years of this century the telecommunication and electric companies were tapping the market extensively. Both GE and ATT issued their first convertibles during the previous century’s first decade.
The investor base is now made up almost exclusively of technically sophisticated hedge funds or specialist investors. This enables deals to be done at high speed, even with the most complicated deal structures (deal structures vary considerably) because the audience can be trusted to understand them rapidly and make commitments. The “Rule 144a” private placement, to be sold only to sophisticated institutions, is frequently used.
Because of this core of dedicated investors, the secondary market lacks transparency. Bonds trade only on an over-the-counter basis and there is no centralised information source for price quotes. Price transparency has actually deteriorated over recent years because American issuers have gradually abandoned the Eurobond market, where pricing transparency is imposed by ISMA. All issuance now takes place in the US domestic market, where no comparable body exists.
The American convertible market acts like a clique. Very little attempt is made to draw in a wider universe of investors who may prefer a more “user-friendly” market and this creates a barrier of entry to new investors. The existing investor base is happy to have these types of opportunities available just to them. Issuers are happy to exploit the situation rather than improve it because it offers a way to issue complex financing packages in very rapid time frames.
The European convertible market is in many ways the complete opposite of the American market. It has long had a sizeable dedicated investor base among the community of traditional private banks and retail investors, who find convertibles attractive for the low risk of capital loss while retaining exposure to equity upside. The dependability of this client base has enabled many European corporations to finance through convertibles on very attractive terms, but normally on the condition that the issuers are of superior credit quality and that deal structures are simple.
Representation of the various countries has been irregular. The private banking culture in Switzerland means that there is a very stable convertible bond investor base which most of the largest Swiss corporations have tapped for funds. France also has a strong retail investor base for convertibles.
Representation has broadened recently with the introduction of the euro acting as a catalyst for change which has affected the convertible market in three ways. First, it has precipitated a restructuring of corporate ownership and the large financial conglomerates have taken to using the convertible bond as a means to unload their holdings. Swiss Life, Allianz and Deutsche Bank have led the way with this so-called “exchangeable” structure.
Secondly, a harmonisation of the legal and regulatory structure has opened some entirely new markets. Until 1996 there were no convertible bond issues from German companies because the regulatory environment made them uneconomic. A gradual change in the regulations has unleashed a slew of issues, with the German market growing to its current size of $19bn. Thirdly, the introduction of the euro liberalised the European financial system and opened the capital markets to many new potential issuers. The strong rally in bond and equity markets made the convertible structure particularly attractive to many of these capital market debutantes. In combination these influences have caused the European convertible market to triple in size in three years, to its current size of just over $130bn, and at the same time to develop a broader selection of both issuers and investors.
The origins of the market as a favourite of the private banking community has also driven it to impose a measure of pricing transparency. Under the auspices of ISMA, formerly the AIBD, there are self-regulated rules for establishing price quotes. Price transparency is currently enhanced by a very competitive environment amongst the regions leading brokers, all of whom seek to publicise their presence in this market by making very competitive two-way prices in the more liquid names.
For a very considerable period of time Japan was the largest convertible bond market in the world. In the absence of a proper corporate credit market and also as a way to bypass the onerous processes of an equity issue, the equity-linked structure, whether convertible or bonds-with-warrants, has always been a favourite in Japan. Throughout the early 1990s Japanese corporations were issuing convertibles extensively. At the time equity prices were falling and therefore no older issues were being converted, causing the market to grow to a size of $200bn and accounting for well over half of the global market in convertible bonds.
1996 saw the peak of this trend and Japan’s profile in global convertible markets has progressively declined since then. Older issues have matured, new issues have effectively dried up and other regions of the world have taken greater prominence. Even so the Japanese convertible market remains formidable in scale and breadth. There is a broad representation across all sectors represented and most of the companies which issue convertibles are in the upper tier of credit quality.
The large domestic financial institutions are the main buyers of the convertibles, while also often being the main shareholders in the issuing companies. Issuers do not have a strong card to play in negotiations and essentially they accept the terms dictated by these institutions. These involve traditionally a conversion premium of less than 5% and a yield that provides a significant degree of downside protection. These are very attractive terms for investors, the only problem being that overseas investors can rarely purchase at issue price as the domestic institutions are allocated all the bonds. Even so, there is invariably an opportunity to acquire these convertibles at a small premium to issue price by purchasing in the after-market.
The market for these instruments is transparent, price and size being displayed immediately on the exchanges where the convertibles are listed – normally Tokyo but sometimes Osaka and the smaller regional exchanges. However these posted prices give only part of the story. Much of the trading activity takes place away from the exchange on an “over-the-counter” basis and is then put through the exchange. These represent the trades taking place with domestic institutions who are compelled by law to put them through the exchange. Offshore accounts are not affected by such a law and consequently a significant proportion of trades, particularly those involving hedge funds, take place off-exchange and go unreported.
Less developed markets can experience sudden enthusiasms for international convertible bond issuance when circumstances combine to make them attractive. Normally these circumstances entail a level of demand from external investors that cannot be satisfied by the local equity markets. If this combines with a currency regime that makes local investors relaxed about taking on foreign currency debt, say when local interest rates are punitively high or the local financial infrastructure is poorly developed, the convertible bond offers a very compelling financing option. It offers both low interest rates and the possibility of being converted into equity capital and thus never having to be repaid.
The markets of Asia ex-Japan took advantage of just such a set of circumstances in the early 1990s and over $40bn of issuance was seen in a very short period from issuers in Thailand, Malaysia, Korea, Philippines and Indonesia. As has been well documented, this episode ended badly for the issuers who had been far too complacent over their currency risk.
This experience continues to act as a deterrent to all potential issuers from these and other lesser-developed economies. This is unfortunate for investors because the aggregate experience of convertible investors over this period was extremely positive. They managed to exploit the burgeoning equity prices in the early stages of the boom and then take refuge as foreign currency creditors after the collapse. Notwithstanding a small number of high-profile defaults, there was a good recovery rate for investors in these convertibles and the overall losses incurred after the collapse were very small in relation to the equity gains made earlier.
There are convertible bonds issued in the local markets which can frequently be attractive alternatives to the equity but by and large international investors limit their interest to eurobond issues, which are issued under ISMA rules. Price quotations are transparent but the nature of these instruments is such that dealing usually requires some negotiation except in the most liquid circumstances.
Adrian Hope is a senior vice president at Jefferies International, in London
A full analysis of the characteristics of convertible bond investment can be found in Global Investment Strategies for International Convertible Bonds by Adrian Hope, available from Jefferies International, Bracken House, 1 Friday Street, London EC4