Dec 2008-Jan 2009

CONVERTIBLE BONDS: the best of both worlds

Convertible bonds offer investors the security of fixed income with the possibility of equity-like returns, writes Mike Reed, a senior portfolio manager at BlueBay Asset Management... In recent years, there has been increasing demand for convertible arbitrage vehicles. For investors, the most important and obvious benefit of adopting a convertible arbitrage strategy is the ability of the managers to modify the fund’s exposure between equity, credit and volatility as market conditions warrant.

In addition, for long-only investors, convertible bond investing can often be the panacea to solve their problems, as it offers participation in the equity market, with significant downside protection. Although not immune from market turmoil, the long-term attractions remain in place and the current impasse in credit markets could offer investors a compelling opportunity.

Why now?
Convertible bonds are currently trading at or near all-time lows as the rise in risk aversion has pushed up credit spreads and forced down equity prices. The upside to this is that convertible bonds are more attractive than at the low point reached in 2002 at the bottom of the last cycle.

In our opinion, such dislocation in the market has created real opportunities that have not been seen for some time. Admittedly, the risk of the further unwinding of hedge fund assets could mean prices could go lower. However, we believe the long-term attractions of this method of investing are good and the current impasse in the credit markets offers convertible bond investors the opportunity to buy assets at what are compelling valuations.
Robust issuance
2007 saw a record amount of issuance in the convertible bond market, with $197.9bn (€149.2bn) of new paper recorded. This represents a 162% increase from 1997, with the US, Europe, the Middle East/Africa and Asia ex-Japan all making notable contributions. The year saw some of the largest ever convertible bonds issued, with several multi-billion dollar equity-like issues from financial institutions.

The total market capitalisation for convertible bonds is worth approximately $550bn. The US has generally accounted for the lion’s share of global issuance – approximately half the total. In Europe, convertible bond issuance, which had been waning prior to 2007, picked up dramatically in 2007, with approximately $40bn of issuance. The high levels of global issuance continued into the first half of 2008 but this window was effectively closed after the summer with the continued market turbulence.

Convertible bonds – the basics
A convertible bond is a form of debt which is exchangeable into equity at a fixed ratio. The debt has a fixed redemption value and generally carries a lower coupon payment than a similar plain vanilla bond. It is, in essence, a combination of a bond with an embedded equity call option. This gives upside participation in the equity and downside protection from the fixed income element.

The change in the dynamics of the convertible, depending on the share price, allows arbitrage investors to benefit from equity volatility. The higher the volatility there is in the market, the more valuable the embedded option in the convertible. Typically, it is only worthwhile for investors to convert from bonds to shares at maturity in the event of the equity underlying the convertible being worth more than the redemption value of the bond.

Because convertible arbitrage investors retain the option to convert the bonds into the underlying shares or receive cash at redemption, they can identify value in the optionality throughout the life of the security. This is commonly referred to as the ‘embedded option’ or ‘equity option’ in a convertible. The value of this option depends on a number of factors including the current share price, interest rates and volatility. Many convertible arbitrage strategies seek to profit from the mispricing of the volatility element of the option.  
The benefits
Asymmetric pay-off profile: For long-only investors (also referred to as ‘outright’ investors), the appeal of this type of investment is that they can obtain equity-like returns with significant downside protection. Moreover, convertibles are particularly attractive to outright investors when equity markets become more volatile. This asymmetric return profile matches that of many structured products, but transparency and liquidity are greater with convertibles and bid-to-offer spreads tend to be tighter.

For hedge fund (or convertible arbitrage) investors the opportunity to trade the probability of conversion at maturity is a compelling attraction. Convertible arbitrage investors are able to take advantage of the option to convert at maturity during the life of the bond.

Flexibility: One of the main attractions of the convertible arbitrage market is its ability to focus on many different angles of the capital structure due to the multi-faceted nature of the securities. For fund managers, this type of strategy gives them the ability to increase or decrease their exposure as market conditions change. This characteristic has given the asset class broad investor appeal. The flexibility and evolution of the convertible bond asset class is evidenced by the growth of the equity-linked instruments in regions such as the Islamic bond market. In the Middle East, issuance has grown to more than $11bn in two years. This has given issuers access to global capital markets on attractive terms and investors exposure to Middle East equities.

Low correlation: The low volatility of convertible bonds (when compared to equities), combined with the exposure to corporate credit, and equity volatility, makes this type of investment strategy ideal for multi-asset portfolios where the quest to find uncorrelated sources of return are paramount.

Equity-like returns: Convertible bonds have the potential to offer equity-like returns with the added benefit that such returns can be generated at a lower volatility throughout the market cycle than that of a straight equity investment. Investors are, in effect, getting the best of both worlds.

The closure of credit markets: The credit turmoil which has engulfed markets since June 2007 demonstrated that convertible bonds were not immune to the drying up of liquidity. Convertible bonds, it must be remembered, are still a funded product and some funds use a high amount of leverage in order to finance their positions.

However, with the Libor rate having scaled new heights in the face of tighter credit conditions, all funded products have suffered.  Some investors have been forced to sell their most liquid positions in order to meet investor redemptions. In addition, the significant deleveraging in credit strategies, including convertible bonds, has had a notable adverse impact on the convertible bond market. ©2008 funds europe

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