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Convertible arbitrage

The Case for Convertible Bonds in 2019

Want to share some takeaways I had after reading Jefferies’ Feb 7 2019 report on convertible bonds (Sean Darby, ‘Global Asset Allocation: An Equity Investor’s Guide to Convertible Bonds’).

  • CB issuance, turnover and liquidity are better than investors perceive
    • Breaking down for market cap
      • by region, among the 314bn issuance outstanding, US accounts for 55% (172 bn), Europe 28% (87 bn), Japan 8% (25.9 bn), Asia Ex 9% (28.8 bn).
      • by sector, IT 18%, Health Care 11%, Con Discretionary 11%, Industrial 10%, Real Estate 9%, Con Service 9%, Energy 8%, Materials 8%, Financials 7%, Utilities 5%, Con Staples 2%.
      • by profile, 37% bond-like (<30D), 41% balanced (30-70D) and equity-like (>70D) 22%. US CBs are more equity-like than European CBs, which are more debt-like in nature.
      • by credit, IG (<200 bps) 59% and HY (>200 bps) 41%.
    • Liquidity is not a constraining factor in the US. The CB market annual volume over market size is 1.9X vs 1.4X in the US HY credit market.
      • US CB volume traded annually= $325bn, market size= $172bn, turnover=1.9X
      • US HY volume traded annually=$1.74tn, market size=$1.22tn, turnover=1.4X
    • Issuance of CB has increased significantly over the past 18 months as corporate issuers attempt to raise capital ahead of rising interest rates.
      • The CB asset class has traditionally boomed in such periods as it gets more expensive for these issuers to issue in the HY market with rising rates. The US issuance has high correlation with US rates. We are likely to see substantial issuance in the coming years, as the rate cycle in both Europe and Asia catches up with the recent US rate hikes.
      • As interest rates begin to rise (Fed continues the normalization policy), the CB issuance is expected to increase as can be seen from historical evidence.
  • Why do companies issue CBs?
    • They are less expansive to raise capital than straightforward equity or bond.
    • Compared with bonds, investors require less coupon in CB.
    • Compared with equities, its ability to deduct interest payments from tax obligations helps lower the cost of capital.
  • The benefits of CBs as an asset allocation tool
    • Convexity- price will tend to fall at a slower rate than underlying equities. CBs offer the potential for more upside than losses on the downside or asymmetric price behavior.
    • Since 2009, CBs has performed in-line with global equities. During equity sell-offs, CBs have protected investors, while providing up-side participation.
    • CBs have tended to outperform other fixed-income asset classes in periods of rising interests (rates tightening cycles). While HY bonds have a tight correlation to equities, they do not offer the same downside protection. Why CBs provide protection during rates hike periods?
      • Firstly, as equities represent a participation in the real economy they generally appreciate in nominal terms as rates rise. This exposure to rising equity prices mitigate the shortcomings in duration.
      • Secondly, CBs tend to have shorter duration than straight bonds. Over the past 20 years, any time US treasury yields have risen by over 100 bps, CBs have tracked equities better than bonds.

The bottom line: CBs offer equity ‘optionality’ with low volatility alongside reduced drawdown. CBs’ asymmetric structure combines the best of equties and bonds, making them a perfect diversification tool as Central Banks normalize policy.

Convertible arbitrage, Investing

Why convertible bonds

The basic premise behind a convertible bond is to combine a bond with a call option, providing an investor the chance to participate in potential equity appreciation, while mitigating downside participation with bond-like characteristics, specifically, a periodic coupon and principal repayment at maturity.

Why companies issue convertible bond?

  1. When a company is young or otherwise having limited access to public equity market. For many tech or health care firms, they are startups or newer firms without sufficient track record and are thus perceived as risky business. For these firms, convertible bond is often their cheapest option for capital raising, as they may experience high interest expenses when issuing debts (often non-IG) through traditional bonds. Besides, due to the embedded call option on the underlying equity, their relatively high risks (underlying equity volatility) make their convertibles bonds more valuable. This explains that why technology firms account for roughly 35% weights of the BofA Convertible bond index, as the high vol nature of technology sector benefit more from the optionality (compared with the utility sector) and the down-side protection through bond-floor matters more for these high-risk names.
  2. When the equity price is depressed, firms do not want to issue equity at a low price and dilute the existing shareholders. By issuing convertibles, company gains access to capital while delaying the dilution to a later date, when the equity market is at a higher price at which the conversion may takes place. They so can gain access to the same amount of capital through issuance of less shares.
  3. As an alternative to raising a straight bond, the issuer is ale to pay a lower coupon than a bond since the conversion option is valuable to the investor.

Why we should invest in convertible bonds?

  1. An all-weather asset class, combining bond and equity features
    • Upside participation: Access to a long-term call option, benefiting from equity upside potential
    • Downside protection: The benefits of a bond-floor, to mitigate equity volatility and downside risk
    • As a result, convertibles tend to shine during medium to high volatility periods[1].
  2. Guard against rising rates: Convertible bonds perform well during rising rates environment.
    • Convertible universe is a blend of IG and HY issuers. It exhibits high correlation to small and mid-cap equities, low correlation to IG credit, and negative correlation to US treasury bonds.
    • Rates are rising usually during economic expansion period. In a growing economy, many companies may generate more profits with improved financial performance, stable issuer fundamentals and as such, experience stock price appreciation during increasing treasury yields. Stocks tend to outperform bond during these periods. Since a convertible bond’s price is positively influenced by the underlying stock price, their prices are less influenced by changes in interest rates than other fixed income securities. Convertible bonds performed well during several rising rates periods, such as 98-00, 04-06, 09-10, 12-13, etc. It also outperformed equities and bonds during rising rate shocks such as ‘taper tantrum’ in 2013[2].
    • As a result, it has significantly reduced interest rate sensitivity
  3. Diversification benefits and broader opportunity sets
    • In addition to low correlation to IG bonds and US treasuries, convertibles provide diversification with respect to equities and HY issuers. 82% of non-IG convertible issuers are not represented in the HY universe.
    • On a sector basis, the convertible market is heavily weighted towards technology, financials and health care.
  4. Convertible bonds provide high risk-adjusted returns: for a given level of risk, convertible generated greater returns than equities historically.

 

Reference

[1] https://mainstayinvestmentsblog.com/2018/05/convertibles-shine-through-clouds-of-volatility/

[2] https://www.blackrockblog.com/2018/01/18/case-for-convertibles/