Steering towards convertibles
Back at the start of this decade, convertibles were one of the darlings of the capital markets, producing equity-like returns (double-digit in those days) with considerably less risk. Conventional/traditional fund managers and the convertible arbitrage hedge funds, both enjoyed excellent performance. The happy times are gone and returns in recent years have been on the whole fairly dismal. However, managers seem to be reasonably convinced that the bottom has been reached and the outlook for convertibles from now on could be quite rewarding.
“Our convertibles benchmark is the Goldman Sachs/Bloomberg Index which registered only a 2% rise in 2004, a bad year indeed, when compared to the 10.99% rise of the MSCI Europe Index,” says Pierre Lepicard, a manager of Fortis Investments’ convertible bond funds. “What hit convertibles so badly was the unremitting and unprecedented decline in volatility. Volatilities of all markets fell in 2004. Convertible implied volatility went from 29% in March to 21% today.
“When one buys a convertible one pays a premium to get the optionality, and the cost of that option is measured by volatility. With volatility so low, the option price is greatly eroded. What investors in our convertibles funds have liked and indeed benefited from is the convexity: enjoying 65-70% of the upside in equity markets but having protection on the downside and suffering only 30-35% of the loss. With the big fall in volatility, the cost of this convexity is at its cheapest level ever.”
Claude Jeanneret, of Zurich-based convertibles specialist Fisch Asset Management, describes the last few months as something of a mixed ride. “On one side the option value of convertibles has been shrinking dramatically in recent months, and on the other the underlying equities did quite well. A characteristic of the situation was the overhang of sellers, most of whom are running convertible arbitrage strategies. The lower the volatility fell the more these managers were pressured to sell their convertible holdings. Their arbitrage, of buying the convertible and shorting the underlying stock, only works if volatility is good and the value of their longs doesn’t erode. That said, our convertibles long strategies produced quite satisfying returns over the last few months. The higher the indirect equity exposure and the less sensitive the convertibles to the shrinking implied volatility, the better the results.”
Jeanneret and his colleagues think that the worst, in terms of low volatility, may be over. “In certain regions, most especially in Japan, there have been some signs that volatility may have reached the bottom and may be on the point of turning. And if we see this then the outlook for convertibles should be much better.”
Jeanneret continues: “The falling volatility theme is so stretched now, it is two standard deviations below the norm of the last four to five years. We think that convertibles are now good tools at a cheap price. We are currently at that point in the cycle where interest rates will probably rise further but are still at an advantageous level for equities to rise. This stage lasts until interest rates rise enough to make corporates suffer.”
“As we look ahead,” Lepicard adds, “those ‘costs’ of losing the volatility are now behind us. Convertibles can now be revisited in the context of low interest rates, tight credit spreads and equities gaining some momentum. Thus it is very likely in the context of rising equity prices that we will enjoy a large share of the gains.”
As well as falling volatility rates, investors in convertibles also had to contend with diminishing supply in 2004. Lepicard is concerned that supply is indeed a problem in Europe at the moment. “If we consider the corporate cycle, as companies get more profitable, instead of investing they tend to pay down their debts. We have seen a great shrinkage of issuance in Europe. And with such low volatilities, and interest rates, the benefit for an issuer of going the convertible route is marginal in terms of coupon, unless the issuer credit is weaker.”
Lepicard says: “At Fortis we dealt with the lower European supply and declining volatility through custom-made convertibles. Asking banks to issue exchangeable bonds on the underlyings (stocks) we like, when we wanted to get exposure. Banks have such a large volatility overhang in their books that the pricing of such products is very competitive.” The Fortis convertibles team is moving more into the global stage, as other regions such as Asia offer better growth and opportunities in convertibles.
Part of the ‘problem’ with convertibles is that their complexity deters many investors. The fact that convertibles straddle both bond and equity markets is another reason for investors to steer away. These hybrid securities may behave like straightforward fixed income bonds at some stage or have the pricing behaviour of a common stock at other points. To tackle a convertible, investors need to have an understanding of, or access to, both credit and equity analyses and at least some knowledge of the ‘dark’ world of derivatives. And knowing the reams of jargon helps too.
In its simplest form, a convertible is a fixed-income security with a call option attached. This option gives the holder the right, but not the obligation, to convert the bond into a certain number of common stocks (of the entity which issued the convertible bond) at a predetermined price. It is this embedded conversion feature that gives a convertible bond its equity-like properties and which means a convertible bond has a lower running yield than a plain vanilla bond of similar coupon and maturity.
That a convertible bond would be issued with a lower coupon than a plain vanilla bond is one of the attractions for a company wishing to raise capital. The lower coupon means that they have less debt servicing to do over the course of the life of the bond. Of course they have paid for this in the granting of the option to convert the bond into a certain number of their stocks at a certain price, but it does mean that they have got the cash up-front without initially giving away their shares. And as they have set the conversion terms, they have ensured that their shares are not bought too cheaply.
The graph below shows the relationship of the convertible bond price with the equity price. The red lines chart the possible prices of the convertible at its maturity. During those periods when the actual share price is at or below the conversion price, the convertible behaves like a bond – who would bother converting when they could go to the stock market and buy the shares directly? However, once the share price starts to rise above the conversion price then the convertible price will tend to track that, hence the line slopes upward. So in an ideal world, the owner of a convertible gets to join in the share’s upside, and also is protected from its downside, in other words ‘convexity’ at its most beneficial.
It’s not that simple, the yellow line depicts the price of a notional convertible which is not at its maturity date. The price of the convertible depends on a number of factors, some relate to the bond market, others to the stock market, and to the option valuation. The major drivers are: swap rates, credit spreads, supply/demand dynamics, event risk and volatility. Historically, convertibles have tended to have a very low correlation to bonds but a high one to equities.
Volatility is a primary determinant of an option’s price and thus an important driver of the convertible’s price behaviour. A high volatility suggests that there is a good chance that the price will change a lot. For the owner of a convertible with its embedded call option, the higher the volatility the better the chance that the stock will jump higher, the better the chance the call option will be worth more in the future. An option usually costs more at the time of purchase if it has a high chance of being worth even more in the future.
Greek letters are used to describe the various sensitivities of convertibles. A convertible’s sensitivity to the underlying equity price is the ‘delta’; ‘omega’ is the measure of its sensitivity to credit spread; ‘rho’ to interest rate sensitivity; ‘theta’ to the passing of time; ‘kappa’ or ‘vega’ to movement in the implied volatility of the option; and finally ‘gamma’, which is the measure of the sensitivity of a convertible’s delta to movements in the underlying equity.
Critics argue that the ‘jack-of-all-trades’ nature of convertibles results in them being not particularly good at anything: fans argue that this versatility means they can be used to implement a diverse range of investment strategies.