The relationship between convertible securities and investors has been marked by bursts of intense admiration followed by equal to longer periods of distrust and avoidance. While liquidity and valuation dynamics offer insight into the volatile nature of this relationship, they do not fully account for its drama.
Over the past 20 years, convertible debt as an asset class has outperformed both the S&P 500 index and straight debt on total return basis. This alone should garner eternal investor devotion—a feeling that should be strengthened by the fact these returns have be achieved with far less risk given the hybrid structure of convertible bonds. Unlike straight equity, which gives investors downside risk as well as upside exposure, convertible bonds provide principal protection in the form of a par repayment obligation at maturity (typically after five to seven years). This fundamentally improves the risk and volatility profile of the investment.
Meanwhile, the equity component or “call option” imbedded in convertible debt gives investors participation in appreciation of the underlying equity at a fixed premium to its price at issuance (typically 20-40 percent). Investors accept a lower fixed yield on the debt in return for principal protection and this upside participation. Unlike traditional call options, however, these are long dated (typically five to seven years), adjust for dividend increases above that of the stock yield at issuance, and pay interest. If at maturity, the stock has appreciated and the call option is in-the-money, the convertible bonds will be worth more than their $1,000 par value and investors will elect to “convert” them into equity, rather than retire the obligation at par. Since equity participation above the convertible notes’ strike price is unlimited, there is no “cap” on the return a convertible investor may realize. From a portfolio perspective, this unique combination of limited downside and participation in equity upside led one recent article to conclude, “If one puts long-only convertible returns into a portfolio optimisation tool, [the result] will not let one own any equities.”
Me Loveth The Return Profile, But Fear Thy Liquidity…
The convertible asset class is by far the smallest of the three majors with U.S. valuation of roughly $300 billion and $500 billion globally. Issue sizes range from $50 million to several billion dollars, with the majority of offerings less than $500 million. In all but the largest issues, building positions of greater than $20 million to $25 million can be difficult. For larger fund managers, this can present a real limitation on their ability to utilize the product. However, position sizes in the $5 million to $15 million range can typically be secured with relative ease. Buying a position in the secondary market is also much like purchasing shares, as most convertible bonds are quoted and trade at levels correlated to movements in the underlying stock. Additionally, given convertibles’ derivative structure—their value being a function or “derivative” of the equity—the securities lend themselves to arbitrage/hedge trading strategies. Many bonds are held by dealers or convertible hedge funds that are long convertibles and short stock against them to offset much of their exposure. Because of this, the purchase or sale of convertible debt is often more a function of one’s ability to cover or establish a short position in the underlying stock, than finding a direct, fundamentally driven counterparty. Said differently, in the case of many convertible securities, the liquidity of the underlying stock dictates the liquidity of the convertible debt.
This dynamic also explains the “lack of liquidity” criticism leveled at convertibles during periods of market turmoil. An oft-heard cry is that sellers have difficulty reducing convertible exposure during crises. What is actually being experienced is a failure of liquidity across all markets. When this happens, stocks typically can’t be sold without material price impact, and corporate debt markets also experience declines in liquidity and price as the perception of risk rises along with interest rates. Declines in liquidity and price across both correlated markets (equity and debt) can amplify price movements in convertibles. Additionally, in periods of severe market dislocation, a breakdown or recalibration of the securities’ fair value may occur, reducing support levels and exacerbating investor’s sense of a liquidity vacuum. While certainly frustrating and of concern, such liquidity gaps or downdrafts, really just a temporary backing up of bids, tend to be short-lived and almost always snap back with a profitable vengeance. The last major liquidity gap in 2008 presented the perfect storm for convertibles, with dealers and hedge funds forced to reduce exposure at the same time. Experienced investors with dry powder provided liquidity at deep discounts to fair value and have since realized outsized returns on the positions they acquired.
Since 2008, the financing strategies and leverage that precipitated the aggressive sell-off of convertibles have been fundamentally rethought. So while it is hard to imagine a liquidity crisis of that magnitude again, it is reassuring to know product-knowledgeable investors recognize the value of the debt characteristics imbedded within convertibles and stand ready to provide liquidity if required.
Valuation, Tho But A Word, Is An Important One…
In the decade leading to the Lehman crisis, there was a steady increase in the dominance of hedge fund participants in the convertible market. At their peak, such strategies were estimated to own as much as 80 percent of the available product. As these model-driven players sought to exploit market inefficiencies, they drove up pricing, forcing many outright funds to contract or consolidate. This imbalance in strategic approach contributed to 2008’s market dysfunction, as too many participants were on one side of the trade to allow for orderly markets. The resulting poor performance forced many hedge funds to downsize or exit the product entirely. As markets have normalized since, the mix between outright and hedge investors has moved to a healthier mix viewed as about equally split between the two. This shift has made valuation in the marketplace more attractive. While larger, better quality bonds remain tightly priced relative to fair value, plenty of issues offer extremely compelling return profiles. Additionally, while historically low corporate rates have crowded out other securities issuance over the past two years, this is beginning to change. The recent backup in straight rates has caused a spike in new convertible issuance—year to date, volume has already eclipsed 2012—providing investors not only product diversity but also a means of establishing larger, more meaningful positions.
At times tragic and comedic, the capricious romance between investors and convertible debt is perhaps better suited for the pages of Shakespeare than the global stage of financial markets. So while investing or not investing in convertibles remains the question, I offer this:
While Emotion May Dictate No…
Logic, low volatility and attractive current and historical returns suggests this not be so.
Jonathan Cunningham is principal and co-founder of Aequitas Advisors LLC in Stamford, Conn.