The convexity of convertibles
The logic for a tactical position in convertibles was clear at the beginning of 2009. CQS told Martin Steward about the strategic case as we enter 2010
When a specialist asset manager attracts $450m from global institutional investors in a matter of a few months, to an asset class to which most would not have given a second thought two years ago, it is time to sit up and take notice. That is the story of the CQS Convertible Opportunities fund, a Dublin-domiciled QIF launched on 2 June 2009.
CQS has a long pedigree in convertible bonds, but when the market dislocated in 2008 - largely thanks to forced selling by the hedge funds that had come to dominate the market - it seized the opportunity to work with pension funds and their consultants, particularly Mercer, to bring the asset class to this new investor base. However, the Opportunities fund is not just a tactical, distressed-value beta product but, in the words of convertibles specialist Peter Warren, "a relatively conservatively managed long-only convertibles fund". Liquidity is tightly managed - monthly, with 60 days' notice - to favour investors with a long view. The portfolio is driven by active, bottom-up credit analysis, diversified by sector and region (with limited exposure to emerging and other less liquid markets), and uses neither leverage nor derivatives (outside of currency hedging).
"We think we can run significantly more than the $450m we have at the moment, especially given the liquidity terms," says Warren.
So the fund is part of, and to some extent depends upon, the ongoing transformation of the convertibles market. Outflows and shrinking credit lines have clipped hedge funds' share of the market, while corporates buying back their securities, ‘crossover' buyers like long-only credit funds, and institutional investors, have filled the gap.
"That's good for strategic investors," says Warren. "If we ever find ourselves in a 2008 situation again there is a much better balance and a much bigger spread of investors prepared to offer tactical support."
After a dead Q1, issuers returned, to the extent that 2009 will have provided a respectable $95bn of new convertibles. These issuers have ranged from investment-grade large-caps like Anglo American and KfW/Deutsche Post, through to the companies with lower implied credit ratings that represent the more familiar face of convertibles. Moreover, the latter have been pricing with an eye to the strategic investor - shorter maturities, meaningful cash coupons - rather than looking to get the technical pricing right for arbitrageurs. More are coming out of Europe, too. As a result, convertibles is now a respectably diverse market, split 55% North America, 23% Europe and 22% Asia, Eastern Europe and Latin America; and also divided pretty broadly by sector (financials, including real estate, now make up just 19%).
But is the strategic story really as compelling as the tactical story undoubtedly was? Back in December 2008, almost half the market traded at yields more than 10% above benchmark. Investors could disregard equity options completely and find dozens of convertibles trading through straight debt issued by the same names: long-only bond managers could sell plain-vanilla bonds, buy convertibles, and pick up 500bps of free yield. Only about 7-8% of the market trades at a 10%+ spread today. But that is still 7-8% more than in 2007; and even now, only 35% of the market trades below benchmark, against 90% during the first half of 2007. There is still juice in these bonds.
"The investors who have come in have made a long-term commitment," says Warren.
To make the strategic case, CQS has gone back to basics - providing information on the long-run performance of the asset class and showing that modest allocations offer meaningful improvement to efficient frontiers. But it also draws attention to the convexity of convertibles' exposure to equity markets - which arguably comes into its own at the kind of inflexion point we are now experiencing. As equities go down, convertibles' delta sensitivity decreases, and as they go up, the delta increases - softening exposure to equity-market downside and boosting it on the upside. As equities have recovered during 2009, average convertible delta has risen from 0.15 to about 0.40. Since its June launch until October 2009 the CQS Convertible Opportunities fund racked up an 8.61% return while global equities made 11%.
"Investors have started to question how much further risky assets can go - perhaps regretting that they haven't captured as much of the bull market as they might," Warren observes. "They are nervous about jumping straight onto equities, but don't want to sit on government bonds and watch equities rally further into an inflationary environment, either. Convertibles provide an asymmetric exposure to that risk, as well as a yield cushion: that feels very natural for institutional investors struggling to make sense of a big tactical move in risk assets on the back of weak-looking fundamentals."
Finally, of course, although the beta story has been great, convertibles remain a tremendous source of alpha, and CQS prides itself on credit analysis that can challenge all-comers. "We have a lot of intellectual property around convertibles," says Warren - referring to the firm's 12 dedicated analysts in London and Asia. "That really counts when a good part of your market is non-rated."
That "good part" is 41% of the market, to be exact - and 24% of the CQS Convertible Opportunities fund. The conservatively-managed fund has much greater exposure to securities rated BBB or above than the market, and is also more diversified regionally and sectorally - a robustness bought at the expense of significant tracking error to the broader market, of course. "We will happily stray a long way from the benchmark as long as we can continue to be a very well-diversified portfolio," says Warren. "And, so far, the portfolio has done exactly what we set it up to do - capturing the returns of investment-grade convertibles with significantly lower standard deviation."