Quality of issuers underpins European convertible
Convertible bonds are a separate asset class that calls for specialist management. Although they are typically classified as fixed income instruments, they have unique characteristics offering the investor the combined benefits of fixed income and equity investment.
A convertible bond – legally a debt security – can be modelled as a straight bond offering an added guarantee of capital. Thus, managing a convertible portfolio has a lot of similarities with managing a fixed income portfolio.
However, the embedded option gives the holder the opportunity to participate in the capital appreciation of the underlying stock. The convexity of convertible bonds allows the optimisation of the risk and return performance. When rates are declining, the equity exposure is reduced to a return floor defined as follows: government bond yield plus default premium. When the underlying stock appreciates, the modified duration of the convertible bond mechanically increases. The asymmetric payoff offered by a convertible bond portfolio could not be replicated in a mixed portfolio without incurring higher costs.
Over the past years, the European convertible bond market has undergone significant changes in size and diversity. The market capitalisation now totals e125bn, three times the amount of eight years ago, accounting for 30% of the world capitalisation. Historically, three countries were the main issuers: France, Switzerland and the UK ; others have joined since, such as Germany, Italy and the Netherlands. Most sectors are now represented and the risk spectum is distributed across countries and sectors.
The European convertible bond market has a specificity: the quality of the issuers. US issuers are essentially small growth companies, while most European issuers are large companies benefiting from an official rating: as of today, only 7% of issues have a rating inferior to BBB.
Such quality of signature has significant impact on a convertible bond portfolio, as it offers relative stability to the investor when spreads are widening. This European specificity results partly from the large proportion of exchangeables in the convertible universe. In Europe, a number of companies settle cross holdings via the issuance of exchangeables. The average maturity of a European convertible bond is less than five years. Most recent issues have shorter maturities than five years ago. It obviously impacts the modified duration of a convertible portfolio – the reference rate being the five-year risk-free rate.
1999 was a record year with issues totalling e30m. Given the the increasing number of financial operations initiated all across Europe, we expect the market to grow at increased pace over the next years.
We take an original approach to the management of convertible bonds, offering the investor the experience of both equity and debt expertise. Central to convertible bond management is convexity: the portfolio managers aim at preserving an equity exposure close to 50%, allowing them to benefit from potential appreciation of the underlying security while keeping a close proximity to the bond floor. The standard exposure will then be increased or decreased according to the our strategy team’s forecasts. If we are overweight on equity, the global delta of the portfolio will be around 60%. The first step of our process is the determination of exposure limits – both upwards and downwards – to prevent the portfolio transforming itself into either a bond or an equity portfolio and thus losing all its appeal for the investor.
The second step of our process is the selection of securities – which we believe is key to outperfomance. This is based on three in-house skills: financial analysis of the underlying stock, technical analysis of instrument and issuer’s credit analysis.
Our equity research team provides for financial analysis. Together with the European equity managers, they produce overweight/neutral/ underweight rankings which the convertible portfolio managers actively refer to when picking stocks.
Technical analysis is essential to the construction of the portfolio. We use a software application based on the Cox–Ross–Rubinstein model providing real-time valuation of all European convertibles. The model is fed with various hypotheses specific to Indocam such as issuer’s signature, volatility of underlying stock, stock return. The output of the model allows us to assess the relevance of investment decisions.
Apart from the theoretical price resulting from the model’s computations, the equity delta, the modified duration and the proximity to bond floor are essential elements in our decision making process.
Technical analysis is very much dependent on credit analysis, as the latter is essential to the assessment of the risk level that will be fed as an hypothesis into the model. Our credit analysis team provides information on peer group analysis, issuer’s ratings, public/private sector spreads – just as in traditional debt management.
The third step of our process is the construction of the portfolio – carefully weighting the selected securities into the desired convexity.
We have been managing convertible bonds as a separate asset class for the past 11 years. Assets under management totalled e955m at the end of 1999. The convertible bond portfolio managers are integrated into the European equity team.
Fabienne Girard-Tokay and Maxime Royet are convertible bond managers at Indocam in Paris