Convertible bonds: key lessons from 150 years of issuance
Beat Thoma outlines some of the key lessons from 150 years of convertible bond issuance
It is roughly 150 years since the first convertible bonds were issued by the Rome, Watertown and Ogdensburg Railroad. Unable to finance an ambitious project to build one of the first railway lines in the US from its own capital, the company made history issuing a convertible bond with a maturity of 30 years, a coupon of 7% and a value of $1,000. In today’s money this would equate to roughly $200,000 (€176,000) per bond and a total issuance of between $1-2bn.
The convertible bond market has progressed substantially since its genesis in 1874. Its appeal to investors is unsurprising, providing significant upside when share prices rise in buoyant equity markets while offering downside protection when they fall. Such characteristics make them hugely effective in volatile markets or times of uncertainty. With political and macroeconomic risk set to be key themes for 2015, what important learnings lessons can be taken from the past 150 years of convertible bonds to ensure investors are able to fully take advantage of this unique asset class? Here are three to start with:
• Do detailed credit research. Investors cannot ignore the importance of detailed credit research. In the years following the Rome, Watertown and Ogdensburg issuance, hundreds more railroad bonds hit the market. By today’s measures, the total volume far exceeded the NASDAQ hype of 2000. Interestingly, during this initial convertible bonds market boom, the issuing conditions were all similar, with coupons hovering around the 7% mark – despite the underlying risk of each project varying substantially.
Herein lies a valuable lesson. Anyone who invests in convertible bonds must put credit research at the centre of their decision-making process. More detailed analysis from convertible bonds original investors may have revealed that the Rome, Watertown and Ogdensburg convertible should have offered a considerably higher coupon and a shorter maturity.
• Manage portfolios actively. As the convertible bond market grew in popularity in the early 1900s, the importance of active management became clear. By this time many household names including General Electric, Westinghouse International Paper and Western Union had undergone issuances. Then came the stock market crash of 1929 and as equity markets collapsed only high-quality issuers were able to survive.
“Anyone who invests in convertible bonds must put credit research at the centre of their decision-making process”
These businesses made good on their convertible bond obligations, providing investors with downside protection. With the convertible bond issued by Richfield Oil Company in 1928, an investor was able to survive the turbulence in excellent shape. Crucially, at the end of the downturn, investors were able to take the capital salvaged through the convertible and reinvest this in equities at a very inexpensive level. These anecdotes serve to highlight the importance of active management, particularly in an asset class where the risk-return profile can vary substantially over time.
• Analyse every aspect of the bond. In the period from 1935 to 1970, the first valuation models were introduced to analyse convertible bonds more precisely (long before Black & Scholes). This period brought the insight for current investors that a precise analysis of convertibles is a key to success. One only has to consider the many new issues in highly different conditions in today’s market to get a sense of the sophistication and technical knowledge required to make informed decisions. This is typically a multi-stage process analysing not only the credit risk and optionality in terms or puts or calls, but also the underlying equity and its exposure to macro-economic or sector trends.
“To this day, one of the most important maxims for convertible bonds is to separate the wheat from the chaff”
As the market continued to mature, the development of more sophisticated analytical tools also provided investors with the data and insight to exploit a greater range of opportunities from price distortions and work out new forms of convertibles such as mandatory convertible bonds and exchangeable convertible bonds. It also provided investors with a greater sense of clarity on which ‘innovations’ were overpriced, allowing for better distinction between opportunities and non-opportunities. To this day, one of the most important maxims for convertible bonds is to separate the wheat from the chaff.
Since 2000, arbitrage, benchmark orientation, CoCo convertibles and additional innovations such as takeover protection and dilution protection clauses have also emerged. Perhaps the most important event, however, remains the financial crisis and the resulting insight that the bond floor plays an essential role for convertible bonds.
If a share price falls sharply below the conversion price, the convertible will react less and less to small fluctuations. It decouples to some extent from the share price trend and if share prices keep dropping it will settle at a certain level, the bond floor. The bond floor is calculated by comparing the convertible bond with a straight bond (without the conversion right) that has the same residual maturity and the same coupon as the convertible.
Apart from the bond floor, the momentum of the underlying share is also considered an important criterion, providing information not only on the speed and strength of price movements but also on trend reversals. Investors must appreciate these dynamics in a market that is continually increasing in its complexity.
Convertible bonds have come a long way since Rome, Watertown and Ogdensburg Railroad marked the birth of the asset class 150 years ago. Much can be learned from studying the market’s evolution and its behaviour throughout the economic cycle. What cannot be ignored is that convertible bonds offer a wide range of interesting opportunities for investors. They are capable of delivering strong risk-adjusted returns in a global economy where volatility and uncertainty are seemingly ever-present. Understanding their key characteristics is crucial for investors to make informed decisions and manage their risk profile effectively.
Take that ground-breaking first issue, for example. What happened to it? For the keen historians among us, the bond was never converted as the share failed to appreciate substantially and the company had to refinance in 1904. It was repaid almost 50 years later – at a coupon of 5%.
Beat Thoma is chief investment officer at Fisch Asset Management, based in Zurich