Are convertible bonds good for pension funds?
Convertible Bonds are very interesting investment vehicles. This is proven by the research study of Ibbotson Associates, which analyses the long-term comparison between stocks, bonds and convertible bonds in the US. The risk return profile of convertibles is not only superior to that of stocks and long-term bonds. The study also concludes that convertible bonds generate a positive diversification effect in bond as well as in stock portfolios.
In order to get a deeper insight of the diversification contribution in global markets our firm asked the Schweizerische Institut für Banken und Finanzen of the University of St Gall to undertake a study on ‘Convertible Bonds, replication and application in Pension Fund portfolios’. Professor Zimmermann and his team investigated the possibility to replicate dynamically convertible bonds with bonds and stocks or with bonds and options. In the second part, the study analyses whether the inclusion of CB’s in portfolios with and without investment restrictions improves their risk-return-profiles.
According to the study, the replication of convertible bonds is theoretically possible, providing certain conditions are fulfilled. But in most cases the replication reaches only a limited precision. Whether the replication-risk can be accepted depends, according to the study, among other factors on the fact of how and where the replication is applied.
In the second part, the study analyses the period from January1994 until February 2000 . The investment universe consisted of global stocks, global government bonds, Swiss stocks and bonds, global convertible bonds and global convertible bonds at the money. Two different pension fund portfolios were investigated: the first portfolio is subject to restrictions according to the Swiss Pension Fund Law. The second portfolio has no restrictions.
The study concludes that in the case of portfolios with restrictions all optimised portfolios include convertible bonds. Especially for pension funds with a certain risk appetite it makes sense, so the study says, to substitute part of the bond position with convertible bonds. Also, in the case of portfolios without restrictions the inclusion of convertible bonds improved the return-risk-profile. The study says that for the period looked at convertible bonds made a diversification contribution to all portfolios.
Study of the Schweizerische Institut für Banken und Finanzen of the University of St Gall
An executive summary and the entire study are available on the website www.riskreturn.ch