Broadening The Horizon

By Grant Mackie, Pavel Verzhbitsky, Christine Jeannet, Harriet Black, January 22, 2001

Lehman Brothers has published a study on the pros and cons of having convertibles in a traditional portfolio.

Executive Summary

Convertible bonds (CBs) as an asset class have a number of features that make them an attractive alternative to straight equity. A convertible’s price is primarily determined by the price of the underlying equity, so CBs are essentially an equity instrument. However, they have often been overlooked by equity portfolio managers unwillingto step outside of the traditional equity universe. The main reasons why we believe that such investors can improve performance of their portfolios by including convertibles are as follows:

• Asymmetric payoff:
• Return enhancement:
• Risk reduction opportunities:

The risk-reduction opportunities offered by convertibles can be illustrated with simple examples of portfolios consisting of real-life securities, and a significant portion of this document is devoted to the description and analysis of two such examples.

In summary, despite certain drawbacks, such as the lower liquidity and the need for at least a basic understanding of this relatively complex instrument, convertible bonds are a powerful tool at the disposal of an equity investor. Ignoring this tool can mean putting oneself at a disadvantage in the increasingly competitive asset management industry.

Outline Of The Paper

The purpose of this paper is to demonstrate how equity investors can benefit from including convertible bonds in their portfolios, focusing on the risk-reduction opportunities offered by convertibles. We provide a brief description of what convertible bonds are and the related terminology in Appendix 1, and Appendix 2 contains a summary of mean-variance (MV) portfolio analysis and efficient frontiers. Lastly, Appendix 3 provides an overview of the existing European convertible market subdivided by economic sector.