Capital Markets. Convertibles. A Hybrid For All Occasions?

By Landesbank Baden-Württemberg , 1 July 2002

• Current developments in the convertibles market (as of 2002).
• 5 convertibles strategies (junk strategy, bond strategy, hybrid strategy, equity strategy, discount strategy)
• Portfolio aspects (lowering volatility, diversification, added return in bond funds)
• Alternative investments with convertibles (arbitrage - cash flow advantage, delta hedging)
• Overview of convertibles (sorted alphabetically and according to 5 convertibles strategies)

View / download study (PDF / german / 39 pages / 850 KB)

 

Executive Summary

 

The convertible financial products segment has grown strongly in the euro region during the past decade, both in terms of quantity and quality. In 2001, the issuing volume exceeded the mark of EUR 50 billion for the first time. Moreover, the number of issuers in the meantime makes it possible to achieve broad diversification in all economic sectors.

 

The growing importance of exchangeable bonds increases the attractiveness of and interest in this asset class. Investment companies have already responded to this development in that they are increasingly launching funds focusing on 'convertibles'.

 

The performance of convertibles

 

Convertible bonds exhibit a hybrid form, i.e. they possess characteristic attributes of bonds on the one hand and of equities on the other hand.

 

This trait is also reflected in their price trend. Five distinct price segments can be identified in which convertibles display different sensitivities to the various influence factors:

 

• 1. Junk
• 2. Bond
• 3. Hybrid
• 4. Equity
• 5. Discount

 

In general, the smaller the conversion premium becomes, the more closely the price trend of a convertible follows that of the underlying equity. However, the larger the conversion premium becomes, the more the convertible is influenced by price factors relevant to bonds.

 

Portfolio aspects

 

The performance of convertibles during the period of 1996-2001 was impressive: Based on the trend of the UBS Warburg Convertible Bond Eurozone Index, they produced a higher return and exhibited lower volatility than the Dow Jones Euro Stoxx, thus making them extremely appealing from a risk/return perspective. Moreover, by adding convertibles to equity and/or bond funds, it is possible to achieve further diversification effects.

 

Convertibles are suitable for both equity portfolios and bond portfolios. In equity portfolios, they can be employed as an added safety measure in order to better cushion price setbacks. But in order to benefit from price increases as well, they should exhibit a modest conversion premium.

 

Convertibles also usually offer an income advantage, i.e. their regular interest payments are higher than the dividend yield.

 

In terms of bond portfolios, on the other hand, the offensive aspect is the primary focus: In this instance, the convertibles are supposed to produce an added return in the form of price increases (capital gains). This can be done, without engaging in unnecessary risks, by exchanging the straight bonds for corresponding convertibles with a modest investment premium and a long maturity. Significant price increases in the underlying equity cause the value of the convertible to appreciate.

 

Hedging and arbitrage possibilities

 

Assuming that the possibility of equity borrowing exists, convertibles offer various efficient possibilities for hedging and arbitrage. Corresponding positioning in the convertible and the underlying equity will result either in higher interest on the invested capital (cash flow advantage) or in gains in the case of significant price volatility in the underlying equity, whereupon investors can benefit equally from price increases and price drops with the same position (gamma trading).

 

The techniques of stripping and swapping are also enjoying increasingly widespread use. These techniques effectively separate a convertible into its two components, the bond and the option, so that they can be traded independently from each other. This makes it possible, for example, to transfer the credit risks to third parties or to generate options that do not customarily exist in the market.

 

Conclusion

 

The statement that convertibles protect against price drops and simultaneously enable investors to participate in price increases is a gross generalization and cannot be maintained in this form. Indeed, it neglects the different sensitivities of convertibles and thus insinuates a uniform price trend. But in reality, anything from price drops to default are certainly possible and have been observed in the past. In-depth credit research is therefore an indispensable prerequisite for investment in this area.

 

Furthermore, the convertible financial products segment is highly heterogeneous, and each individual security must therefore be examined very carefully in order to avoid unpleasant surprises.

 

Despite these considerations, convertibles exhibit several very attractive characteristics that can optimize both equity portfolios and bond portfolios, thus justifying the increased research efforts.