Investment Success through Convertible Bonds

Summary

Convertibles are bonds which in addition to providing interest payments (and capital repayment) also include a conversion privilege. This privilege entitles the owner of the convertible to exchange (convert) the bond into a specified number of common shares of the issuer and can therefore be viewed as a call option. Convertible bonds are a relatively complex instrument, but they offer diverse risk profiles and can be employed very flexibly

The advantages for investors, and especially also for pension funds and pension schemes, can be summarised as two key aspects:

• positive asymmetry / automatic timing and capital protection
• special risk premiums / convertibles as an inexpensive structure

Financial characteristics

A convertible bond provides the following fundamental risk premiums versus a riskfree investment:

Equity exposure	40%
Credit exposure	35%
Volatility exposure via the embedded call option	15%
Interest income / duration	10%

The percentages express the average relative significance of the individual risk premiums. Each of the listed risk premiums can be purchased separately in the market. A convertible bond has the advantage, however, that it combines all of these premiums in one instrument.

Advantage of asymmetry / timing and capital protection

The asymmetric price behaviourof convertible bonds offers the advantage of an automatic, positive timing effect. In falling markets, protection exists because the bond will be repaid at 100%. In rising markets, on the other hand, the convertible takes on increasing equity character and thus exhibits steadily rising upside participation. This asymmetry corresponds to a ‘dynamic portfolio insurance’ strategy without any of the severe disadvantages of such a strategy (costs, tradability, gap risk).

Especially for pension schemes with limited risk capacity, it is worthwhile to replace part of their equity allocation through convertible bonds in order to capture most of the (attractive long-term) equity risk premiums in a significantly less risky manner.

Advantage of special risk premiums

Thanks to their special structure, convertibles offer a number of additional very interesting risk premiums:

Liquidity premium	40 bis 80 Bps
Premium due to long maturity call option (conversionprivilege)	40 bis 50 Bps
Credit risk premium on the option (conversion privilege)	10 bis 20 Bps
Growth premium (via the structure of the global convertible bond market)	20 bis 60 Bps

The values indicate the estimated additional risk premiums in basis points (bps) p.a. These additional premiums are exclusively available through the purchase of a convertible bond.

The liquidity premium stems from the fixed link between the conversion privilege (call option) and the bond. Both components must be purchased as a ‘package’ and cannot be traded separately. Hence, they are somewhat less liquid than their individual parts.Because of this, however, the investor receives a yield advantage of 40 to 80 basis points p.a., i.e. the convertible is around 1 to 3 per cent less expensive than the sum of a comparable bond plus a call option. This is one of the main reasons for the extremely attractive long-term risk/reward profile of convertibles versus mixed equity and bond portfolios.

The premium due to the long maturity call option (conversion privilege) arises from the so-called ‘fat tail’, i.e. the recognition that larger market fluctuations occur over the long term, especially on the downside, than should be expected based on the generally assumed normal distribution. Hence, call options or conversion privileges should be more expensive than calculated by the standard models commonly in use today, because bigger market fluctuations give rise to higher profit opportunities through options. The longer the maturity of the option, the stronger is the impact of this effect. Convertible bonds generally have conversion privileges withlong expiration dates, from 3 to 5 years.

The credit risk premium on the option (conversion privilege) is another interesting feature. The conversion privilege depends on the bond issuer’s solvency (or ability to deliver the shares). Hence, the conversion privilege is also exposed to credit risk. The value (= implied volatility) of a conversion privilege is therefore lower than a comparable standardised call option. It also holds true here that this effect strengthens as the maturity of the option increases.

he so-called growth premium is especially significant for convertibles from the USA and Asia. In these regions, many growth companies come to the market with convertible bonds. Investors here are to be compensated through direct participation in the share price in the case of success. Hence, an investment in the global convertible bond market entails a certain bias towards attractive growth companies over time

Added advantage of inflation protection

A convertible comprises a so-called ‘exoticbond put’. A convertible which is deep in the money (e.g. at 130% or higher) no longer reacts negatively to rising interest rates. That is because it can be exchanged into the underlying shares at any time. At such point, its value therefore depends solely on this exchange value and no longer on the interest rate level. In contrast, an analogous strategy consisting of a bond plus a separate call option would suffer strong losses on the bond component in the event of rising interest rates (e.g. in the case of an inflationary environment). The bond component of the convertible loses nothing, however, because it can be exchanged into shares. Convertibles are therefore an ideal instrument in an inflationary environment, especially in the early phase of the cycle when both interest rates and share prices are rising.

This ‘exotic bond put’ is completely incorporated in the fair value of a convertible. It is no anomaly or hidden premium (‘gift’). Nevertheless, this feature can be very interesting in certain market environments and is difficult to replicate by other means.

Added advantage of the volatility effect

A convertible bond consists of a bond component and, thanks to the conversion right, an equity component. The conversion right is analogous to a call option. Every convertible thus also reacts to fluctuationsin market volatility. Convertibles therefore involve an ‘option on market volatility’ in addition to the equity and bond components. When an investor buys a convertible bond, he is thus also buying market volatility.

The decisive point here is that thisvolatility component actually reduces the price fluctuations of convertible bond portfolios. The reason for this is the negative correlation of equity prices and market volatility: if the equity market rises, then volatility generally falls (and vice versa). This means that the equity and volatility components within the convertible move in opposite directions and therefore reduce the overall fluctuation of the instrument.

This effect has no influence on the long-term expected return of a convertible bond. It merely moderates medium-term price fluctuations and helps to additionally optimise the risk/return profile of convertibles.

Added advantage of active management of convertibles

Additionally, the global convertible bond market repeatedly offers instances of actual mispricing because the market is not completely efficient due to high hedging/arbitrage costs. Constant market monitoring can therefore produce an attractive added return. Moreover, active management can ensure that the convertible bond portfolio is always in the ‘hybrid’ zone, specifically in the area in which the asymmetry advantage pays off particularly well. To achieve this, convertibles which are deep out of the money (i.e. the conversion privilege has almost no value) and those which are deep in the money (i.e. the conversion privilege behaves like an equity) are systematically sold and replaced through more attractive convertibles exhibiting high convexity. This also automatically produces an interesting ‘rebalancing effect’.