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Convertible Bonds

An Introduction to the Asset Class

Convertible Bonds An Introduction to the Asset Class
Convertible Bonds An Introduction to the Asset Class

DESCRIPTION

 
 

Convertible Bonds (CBs) are fixed income instruments that can be converted into a fixed number of shares of the issuer at the option of the investor. Bonds that are convertible into shares other than the issuer’s are called exchangeable bonds.

Convertibles are fascinating hybrid securities. On the one hand, they have the benefits of debt instruments that pay fixed coupons and will be redeemed at maturity at a pre-specified price. On the other hand, the embedded conversion option provides the investor with a participation in the upside potential of the underlying equity.

The conversion right provides the bond holder with a better-of-two-choices option. At maturity, the Convertible Bonds are worth the higher of (a) their redemption value (the price at which the issuer had agreed to buy the bonds back) or (b) the market value of the underlying shares.

In other words, a Convertible Bond is a straight bond with an embedded equity call option. Due to this call option, the Convertible will participate in any increase of the underlying equity, while the fixed income portion provides capital protection, should the share price fall.

CHARACTERISTICS

 

Payoff profile

Convertible price

Convertible price

Convertible price Convertible price Yield Instrument Yield Instrument Hybrid Instrument Hybrid Instrument Equity
Yield Instrument Yield Instrument Hybrid Instrument Hybrid Instrument Equity Alternative Equity Alternative Bond
Yield Instrument
Yield Instrument
Hybrid Instrument
Hybrid Instrument
Equity Alternative
Equity Alternative
Bond Floor
Bond Floor
Premium
Premium
Convertible Price
Convertible Price
Parity
Parity

Stock price

Stock price

Bond Floor Bond Floor Premium Premium Convertible Price Convertible Price Parity Parity Stock price Stock price
 

Source: RMF Research

The x-axis displays the underlying share price while the y-axis represents the price of the Con- vertible Bond. The dotted diagonal expresses the intrinsic value called parity. Parity represents the value that the investor would receive upon conversion of the bond. Parity is a lower boun- dary for the price of the Convertible. The yellow line outlines the Convertible‘s fair value. If the share price increases, the fair value of the Convertible Bond rises as well. As the share price increases, the relationship between shares and bonds becomes more direct until the bond price behaviour and risk profile resemble characteristics of the underlying equity. On the other hand, if the share price falls, the bond‘s sensitivity to its underlying share price will decrease and the bond will not decline to the same extent as the equity. The level which will prevent the Con- vertible from falling further down is shown in the above graph as the bond floor (grey) which is also a lower boundary for the price of the Convertible.

Similarly to straight debt, a Convertible contains the risk of the issuer not being able to repay the principal at maturity. This credit risk is expressed in the graph as the steep fall of the bond floor as well as the bond price on the left-hand side.

The best risk-return profile is located in the red area where the Convertible’s potential upside is the greatest while the downside risk is relatively low. RMF focuses on Convertible Bonds priced in that area.

CHARACTERISTICS (CONT.) Investment Categories Yield instrument (out-of-the-money) Convertible Bonds where the
CHARACTERISTICS (CONT.)
Investment Categories
Yield instrument (out-of-the-money)
Convertible Bonds where the underlying share price trades significantly below the conversion
price have low equity sensitivity and behave like fixed income securities. The main price
factors are the interest rate level and the issuer’s credit spread.
Hybrid instrument (at-the-money)
Convertible Bonds where the underlying share price trades close to the conversion price are
considered balanced Convertibles because of their asymmetric payoff profile. They have a
medium sensitivity to changes in the underlying equity. These bonds are affected by the
share price performance and volatility movements as well as changes in interest rates and the
issuer’s credit profile. The majority of new issues are launched as balanced Convertibles.
Equity alternative (deep-in-the-money)
Convertible Bonds where the underlying share price trades significantly above the conversion
price are highly sensitive to changes in the equity, whereas their sensitivity to changes in
interest rates and/or credit spreads is low. These bonds trade at an insignificant premium or
even a small discount to parity. Deep-in-the-money Convertibles will almost certainly be
converted into the underlying shares at maturity.
Price Behaviour of
Convertibles
Old
New
Capital Gain/
Cash-
Total
Share Price + 25%
Price
Price
Loss
flow
Return
164
Equity
130
162.5
32.5
1.5
0.3
162.5
Convertible Bond
135
164.0
29.0
4.4
0.2
135
Share Price unchanged
130
120
Equity
130
130.0
0.0
1.5
0.0
Convertible Bond
135
135.0
0.0
4.4
0.0
97.5
Share Price - 25%
Equity
130
97.5
-32.5
1.5
-0.2
Convertible Bond
135
120.0
-15.0
4.4
-0.1
Share Price
Source: RMF Research
Source: RMF Research
Global Performance
across Asset Classes
250
200
150
100
ML-G300 Global Convertibles
In the long run, Convertible
Bonds can outperform pure
equity and/or pure bond port-
folios. The studies further show
that CBs can replicate the upside
movements of the share prices
without the corresponding volatility.
MSCI Global Equities
JPM Global Bonds
50
Source: Bloomberg
Correlation Matrix for
Convertibles and other
major Asset Classes
Intermediat
Intermediate-
Long-Term
Long-Term
Mortgage-
Convertible
Large-Cap
Small-Cap
e-Term
Treasury
Term
Treasury
Corporate
Backed
Real Estate
Bonds
Stocks
Stocks
Treasury
Bills
Corporate
Bonds
Bonds
Securities
Bonds
Bonds
Convertible Bonds
1.00
Large-Capitalisation Stocks
0.83
1.00
Small-Capitalisation Stocks
0.80
0.79
1.00
Long-Term Treasury Bonds
Intermediate-Term Treasury Bonds
Treasury Bills
0.36
0.36
0.12
1.00
0.32
0.28
0.07
0.93
1.00
-0.01
-0.09
0.02
0.00
0.25
1.00
Long-Term Corporate Bonds
Intermediate-Term Corporate Bon
Mortgage-Backed Securities
Real Estate
0.51
0.51
0.30
0.92
0.91
-0.01
1.00
ds
0.52
0.48
0.33
0.90
0.94
0.19
0.97
1.00
0.42
0.35
0.10
0.87
0.91
0.14
0.95
0.93
1.00
-0.02
-0.23
0.34
0.04
0.09
0.25
0.07
0.16
-0.01
1.00
Source: Ibbotson Associates and Goldman Sachs
Correlations above are generally calculated using monthly total returns over the period 1973-
2000. The exceptions are Mortgage Backed Securities, which use the period 1976-2000, and
Real Estate which uses quarterly returns for the period March 1978-September 2000.
Value Index
Dec 94
Jun 95
Dec 95
Jun 96
Dec 96
Jun 97
Dec 97
Jun 98
Dec 98
Jun 99
Dec 99
Jun 00
Dec 00
Jun 01
Dec 01
Jun 02
Convertible Bond

CHARACTERISTICS (CONT.)

 

Efficient Frontier

18%

 

Annualised Return

Market data indicate the advantage of investing in CBs as compared to fixed income instruments and/or equities. The chart depicts the efficient frontier analysis of investing in bonds, equities and Convertible Bonds.

The payoff of Convertible Bonds surpasses the returns achieved by either pure bonds or equities.

16%

14%

12%

10%

8%

100% CBs, 0% Bonds 100% Equity, 0% Bonds 100% Bonds
100% CBs,
0% Bonds
100% Equity,
0% Bonds
100% Bonds
 
 

4%

9%

14%

19%

 

Annualised Volatility

Source: RMF Research

 

MARKET

 

Global Overview

The Convertible Bonds market has been growing over the last decade. The data indicate this trend will continue in the future as both companies and investors become more aware of the benefits of Convertible Bonds. The following map depicts the capitalisation of outstanding Convertible Bonds divided by geographic region (as of December 2001).

 
North America USD 213 bn Europe USD 137 bn Asia (ex Japan) USD 29 bn

North America USD 213 bn

Europe USD 137 bn Asia (ex Japan) USD 29 bn
Europe
USD
137 bn
Asia (ex Japan)
USD 29 bn
North America USD 213 bn Europe USD 137 bn Asia (ex Japan) USD 29 bn Japan
North America USD 213 bn Europe USD 137 bn Asia (ex Japan) USD 29 bn Japan

Japan USD 91 bn

North America USD 213 bn Europe USD 137 bn Asia (ex Japan) USD 29 bn Japan
North America USD 213 bn Europe USD 137 bn Asia (ex Japan) USD 29 bn Japan
 
Asia (ex Japan) USD 29 bn Japan USD 91 bn   The Convertible Bonds Market: USD

The Convertible Bonds Market: USD 470 bn

Source: Merrill Lynch

Market Participants

Long-only investors including dedicated CB Funds The strategy is to generate above average returns via capital gains and interest income while enjoying downside protection and lower volatility. Studies show that Convertible Bond portfolios have outperformed traditional portfolios (50% bonds and 50% equities) on a global basis from 1993 to 2000. During this period, they even outperformed pure equity portfolios (CBs returned 9.92% p.a., while equities returned 9.07% p.a.) (study by Jefferies).

Hedge Funds CB arbitrage is a typical Hedge Fund strategy. The arbitrageur is long a Convertible and short the underlying shares according to the CB‘s sensitivity to its underlying (delta), in order to extract the Convertible‘s ‘cheapness’. If the share price falls, the CB becomes more bond-like and declines less than the share price, so the trader buys back some shares. Similarly, if the share price rises, the Convertible becomes more equity-like and the trader sells more shares. If it is possible to repeat this operation on several occasions, the trader will always be buying low and selling high.

Equity investors As equity investors need or want full upside exposure, their strategy would be to buy deep-in-the- money CBs. They could often generate an income advantage as the coupon yield is typically higher than the dividend yield. Furthermore, they enjoy the benefit of the embedded call option on the underlying equity as well as free downside protection, although that may be rather far away. The investors could also take advantage of in-the-money CBs trading at a discount to parity.

Fixed income investors Fixed income investors tend to buy out-of-the-money CBs that are trading with yields close to their corporate bond equivalents but contain the added bonus of upside participation of the underlying share price.

 

SUCCESS FACTORS

 
 

The following factors are critical for the success of a Convertible Bond investor:

Asset allocation skills because of the wide divergence between returns of sectors and countries over certain periods

State-of-the-art models to keep up with the ever increasing sophistication of the other market participants

Credit skills to assess the corporate bond-type credit risk

Relationships to investment banks for access to new issues and stock borrowing (CB arbitrage)

Market timing skills to protect the capital in extended phases of equity market weakness

Risk management skills to avoid unwanted exposure to all types of risk including interest rate and currency risk

Proprietary trading experience and mentality to take advantage of the relative value characteristics of the instrument

SUMMARY

 
 

In recent years, the Convertibles market has grown at an accelerated pace. More and more companies are willing to look at the advantages of financing through Convertibles, and they find good demand from various investors such as Hedge Funds, Convertible Bond funds or investment banks. We believe that this trend will continue and that this market will steadily gain significance in the future

Convertible Bonds are instruments that are beneficial to both investors and issuers

Convertible Bonds are an asset class with risk-return characteristics that are superior to those of pure bonds, pure equities, or a blend of bonds and equities

The successful management of Convertible Bond portfolios depends on various factors such as asset allocation, security selection and credit skills, state-of-the-art models as well as good relationships to investment banks for access to new issues

200/Q2_02

RMF INVESTMENT GROUP

RMF Investment Group is the leading provider of Alternative Investment Solutions, specialising in Hedge Funds, Leveraged Finance, Private Equity and Convertible Bonds. Focused on the institutional market, RMF’s target clients include pension funds, insurance companies, banks, large corporations and distribution channels. RMF’s headquarters is in Switzer- land, however the Company also has physical presence in the major financial centres.

RMF commenced activities as an operative Hedge Fund Manager in 1992 with an exclusive mandate for one of the world’s most prestigious Market Neutral Hedge Funds. Over the years, RMF has continued to focus on servicing investors by providing comprehensive products and solutions and is regarded as an innovator in the Alternative Asset Management Industry.

In May 2002, RMF was acquired by the Man Group creating the largest independent Alternative Investment Manager in the market, with approxi- mately USD 20 billion under management (excluding Real Estate and Private Equity). As of 30 June 2002 RMF had funds under management of approximately USD 9.5 billion.

RMF is a process driven organisation, and one of the few organisations in the financial services industry to have achieved the ISO 9001: 2000 Certification for Quality Management Systems.

CONTACT

For further information please contact:

Client Relations Team

RMF Investment Consultants Huobstrasse 16 8808 Pfäffikon/SZ Switzerland

Phone

+41 (0) 55 415 87 10

Fax

+41 (0) 55 415 87 94

www.rmf.ch info@rmf.ch

Disclaimer

The content of this documentation is for your information purposes only and constitutes neither a request, nor an offer, nor a solicitation, nor a recommendation to buy, sell or make an investment in the described investment instruments or to enter into or conclude other transactions of any kind. The information provided herein is not intended to provide sufficient basis on which to make an investment decision. Potential investors should note that alternative investments can involve significant risks and the value of an investment may go down as well as up. Furthermore, we recommend you consult your bank, or investment and/or tax adviser. Past performance is never an indication or guarantee of future performance.

Information contained herein is provided from the RMF database or obtained from sources that RMF considers to be reliable. However, although RMF has taken professional care in gathering and updating this material and information, it does not assume any liability in the case of incorrectly reported or incomplete information, accuracy or correctness. All projections, valuations and statistical analyses are provided to assist the recipient in understanding the basics of alternative investments. Such projections, valuations and analyses may be based on subjective assessments and assumptions and may use one among several alternative methodologies (and other methodologies may produce different results). Accordingly, such projections, valuations and statistical analyses should not be viewed as facts and should not be relied upon as a prediction of future events.

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