Convertibles are coming

The simplicity of convertible bonds has attracted new, higher credit quality companies, writes Michael O’Connor. Global convertible issuance has been very strong over the past six years, with difficult market conditions in years such as 1998 and 2001 failing to make a dent in the progress. As of June 2001, $451.9bn represents a very substantial global asset class, despite the impact of difficult equity markets. The growth in convertibles has been driven by a number of different factors. In the US, convertibles have survived the “tech wreck” by attracting new, higher credit quality companies through large, zero-coupon, long-dated securities. Investment grade issuers have replaced the TMT corporates that fuelled the growth of the late 1990s. Issuance has been driven by more accounting and tax efficient structures, principally the rise of the “co-co” structure, which minimises the accounting impact of any equity dilution and “co-pay” bonds, which have an exceptionally favourable tax treatment. Europe has also maintained its upward trajectory, with the insurance sector and telecoms particularly active recently. Convertible issuance has also been boosted by corporate restructuring, as shareholder value considerations have forced a major programme of non-core holding divestments. Asia has stayed on the map thanks to the Taiwanese technology sector and to some high profile “jumbo” issues in Hong Kong and Korea. The real underperformance in the global convertible universe has been from Japan, which has failed to keep pace with the global growth trend. Despite occasional moments of hope, the Japanese market remains moribund, and the long promised exchangeable revolution has yet to get off the ground. Definitions Convertibles have an unfortunate (and totally unjustified) reputation among some investors for being complex instruments. In its most basic form, a convertible is simply a bond, which gives the holder an additional right to exchange the bond into a fixed number of shares. At maturity, convertibles are worth either their redemption value or the market value of the shares into which they convert, whichever is the greater. The convertible shares many bond terms, such as coupons and maturity. Coupons can be annual, semi-annual or even quarterly. As with normal corporate bonds, interest accrues between coupon payment dates according to the conventions of the particular currency’s fixed income markets. As with “straight” bonds, convertible holders will receive the bond’s redemption amount at maturity, assuming they have not converted. In most markets except France, the prices of convertibles (and indeed straight) bonds are quoted as a percentage of their nominal value. Many of the other terms applied to convertibles define the right to swap the bond for shares. The most important of these is the conversion ratio, which is simply the number of shares for which each bond can be swapped. Dividing the nominal value of the convertible by the conversion ratio gives the price at which shares are effectively “bought” upon conversion – known as the conversion price. In basic convertibles, this is the effective “strike price” of the embedded equity option and at maturity (or if the bond is called – see graph opposite) investors should exercise the option (i.e. convert) if the shares are above this price. Most convertibles have early redemption features known as calls, which allow the issuer to redeem the bonds before final maturity, though investors will be given plenty of notice of this and will always have the right to convert instead of taking the redemption proceeds. In almost all cases, convertibles cannot be called for several years from issue. This call protection is important as it guarantees the “optionality” of the convertible. A provisional (or soft) call means the bond cannot be called unless the stock trades above a stated level for a certain period of time. Usually, this level is expressed as a percentage of the conversion price. How to value the convertible bond The graph shows that if the underlying equity performs poorly, the convertible will behave more like a straight bond, while if the equity performs well, the convertible will perform more like the shares. This asymmetric performance shows why convertibles are so attractive, offering equity style upside but with protection if the shares perform badly. Convertible bonds are basically options (i.e. with the right but not the obligation to convert into shares), and as such convertible valuation techniques are very similar in methodology and terminology to those used in the options world. As with equity options, investors feed various assumptions into their convertible model, which then calculates a theoretical value. The critical assumption, as with all options, is volatility and most investors use their convertible model to assess what level of volatility is “implied” by the convertible’s market price rather than calculating a theoretical value. If the volatility that occurs in the shares is higher than the implied volatility paid by investors, then the convertible has been bought cheaply and vice versa. The key sensitivities investors look at are “delta”, the change in a convertible’s value for a change in the underlying equity, and “gamma”, which is the change in delta for a change in the underlying equity. Arbitrage Convertible arbitrage is among the most common of hedge fund strategies, probably because it is also among the most successful. The best convertible arbitrage funds can deliver returns in excess of 20 per cent over the longer term, despite being equity market neutral. Convertible arbitrageurs are essentially trading volatility and as such the implied volatility, delta and gamma are critical. The delta represents the bond’s sensitivity to movements in the share price and indicates to the manager the exact amount of stock he needs to short in order to set up the position. Gamma tells the fund manager exactly how many shares need to be sold or bought if the stock moves. If the stock rises, delta moves higher and more shares need to be sold. If the stock falls, so does the delta and therefore shares need to be bought back. This shows that trading changes in delta (i.e. trading gamma or capturing volatility) is profitable as shares are sold at higher prices than they are bought. The key for the arbitrageur is whether there are sufficient moves in the stock (i.e. volatility) to create enough trades to offset the cost of the position. This is why the manager will compare the implied volatility of the bond (what it costs to set up the position), with the amount of volatility he expects to capture from the equity. Conclusion From the issuers’ perspective, the high demand for convertibles has allowed issuance to remain extraordinarily high this year. Indeed the innovative nature of the convertibles market greatly increases the attractions for issuers with highly efficient structures like co-co and co-pay bonds. From the investors’ perspective, there has never been as much interest in convertibles. The low interest rate environment means many fixed income accounts have looked increasingly to convertibles to enhance the meagre yields available. Meanwhile market volatility this year has amply demonstrated the value of the defensive nature of convertibles to equity investors while continued excellent performance from convertible arbitrage accounts has seen significant capital inflows. The growth in the convertible market looks set to continue. Michael O’Connor is head of international convertible research at Deutsche Bank