Gospel for convertibles
Convertibles are by nature dynamic investment vehicles with changing characteristics. The embedded call option of the convertible is responsible for this fact. In a rising stock market the convertible increasingly participates in the stock market by mutating slowly into a stock substitute. In case of falling prices of the underlying stock the convertible mutates slowly into a bond substitute. This dynamic mechanism relieves the holder of a convertible of the timing question. The convertible inherently owns a correct timing systematic by increasing the stock market exposure in rising markets and vice versa. This is one of the most important reasons for the success of convertible bonds (CB).
Another very important factor for the outstanding performance of convertibles seems to be the low priced long-term option embedded in this investment vehicle. The fact that CB-options are inseparably connected with the bond part might be the main reason for the lower option price . Issuers of convertibles additionally seem to price their convertibles in favour of the investors. Cheap long-term options are very powerful instruments because the decay of time value, a critical issue with options, is no issue at all for the major part of the option period. In most cases convertible bonds are therefore able to realise the advantageous attributes of the embedded option.
The changing nature of the convertible bonds allows a whole set of investment strategies. We distinguish mainly between five strategies (Compare graph): Bond substitute, hybrid strategy, stock substitute, benchmarking and alternative strategies. For each of the five strategies the management has to meet similar demands in order to realise the expected added value. Independent of the applied strategy a high degree of active management is paramount. Experience, know-how and powerful risk management tools are the other prerequisite for the manager to take advantage of the specific market conditions. In what follows we would like to describe shortly the added value for two of these strategies: the hybrid and stock substitute strategies.
One of the most appealing strategies is certainly the classic hybrid strategy. In this strategy the entire CB portfolio is held in the area where both, the bond part and the underlying stock have an important impact on the price of the convertible. This hybrid portfolio represents roughly a 50% bond and 50% stock market exposure. A convertible portfolio which is permanently kept within a narrow range of stock market exposure contains very interesting features. Combined with a rigorous quality and liquidity control of the constituents of the portfolio this strategy has a extremely low downside risk compared to the achievable return. The semi-deviation is nearly as low as for a bond portfolio whereas the return beats bond indices by nearly 2% p.a. This hybrid convertible portfolio is a perfect bond yield enhancement programme. It is comparable to high yield portfolios with the important difference that the average quality is much higher than for a high yield portfolio. These yield enhancement programmes with convertibles can be implemented globally or for single currencies.
Depending on the applied strategy the convertible portfolio is placed at a different point on the non-linear convertible-yield curve and deploys varying risk-return characteristics. In view of an optimisation of the overall portfolio the investor has to decide which risk level should be applied to the CB portfolio . The applied risk level will decide about the equity exposure represented by the CB options. With respect to hybrid strategies the range of stock market exposure reaches from a low of 25% up to around 70%. The manager of the convertible portfolio has to keep the portfolio constantly within a rather tight range, which requires an ongoing risk management process.
This strategy of a defined risk level has clear advantages over a pure benchmark strategy. Depending on the selected benchmark and on the development of the underlying stock markets the benchmark portfolio constantly changes its characteristics with the result of a remarkably high volatility. It may happen during extreme movements of the stock markets that the volatility of the benchmark portfolio is too high or too low and therefore unable to play its role as an optimisation tool for the overall portfolio. Contrary to that our experience shows that the defined risk portfolio is characterised by a surprisingly stable volatility even in a very turbulent stock market environment.
An important point is that for the different hybrid strategies we always hold convertibles with the same technical characteristics. This optimal buying point is there where the relationship between upside participation and downside protection at the underlying stock is very favourable. A strategy with a lower degree of stock market exposure would mean that the portfolio consists also of a certain amount of straight bonds.
The convertible as stock substitute is another very convincing investment tool. Convertibles are bonds with an inseparable call option. But the convertible bond can also be defined as a stock with a put option. A portfolio with equity sensitive convertibles has a nearly 100% of upside participation with the underlying stocks. But there is a big difference to a portfolio of stocks. Each equity sensitive convertible has a put option for free. Although the strike price of this put option is out of the money it provides an efficient downside protection in sharp down moves of the stock market. A well managed portfolio of equity sensitive convertibles, which is able to participate 90% on the upside, but only looses about 50% of a sharp stock market correction.
This is an outstanding downside protection for an equity portfolio. As part of the active management convertibles, which have built up premiums, will be switched into equity sensitive convertibles without premiums in a correction phase. The acquired convertibles again have a very high upside potential with the underlying stocks. Such an equity sensitive convertible portfolio will substantially outperform the pure equity portfolio.
Kurt Fisch is head of Fisch Asset Management in Zurich