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Convertible bonds are less complex than you might think.
We understand why some believe the asset class to be the domain of specialists, but perhaps if we address three of the subjects that present a challenge for investors, convertible bonds will seem much more straightforward to understand. These three topics are:
Yes, there is some math involved. But there are no calculations required if you read further!
Convertible bonds are a corporate bond with an embedded option to convert into shares. This requires work on a fundamental level to have a view on:
These two aspects of valuation should be familiar for most investors, even if the work to do so isn’t necessarily easy.
On the other hand, valuing equity options, might seem like a daunting topic to comprehend. The reason why the creators of the Black-Scholes option pricing formula received a Nobel Prize is that they were able to adapt a model from physics that required only five inputs to price an option:
The sensitivity of the conversion option to these inputs varies, but probably the most important to understand is volatility. This is a standardised measure that shows the potential range of outcomes around a central (mean) value, which is used to determine the probability that the underlying stock might reach the strike price within the life of the option. The higher the volatility, the greater the probability the stock can reach the strike price, which increases the value of the option.
Also, investors can take the value of the option on its own, which one can do for a convertible bond by first valuing the bond component, and solve for its volatility using the current market price. A cheap option would be where the “implied” volatility backed out of the market price is lower than the estimate for future or the actual realised volatility on the stock, or for listed options.
Finally, if we can solve for option values for an individual convertible bond, we can also do so for the entire convertible market. One thing to note is that when we see new issuance in our market, the levels of secondary market valuation are an influence on how a new deal is priced.
A question we often receive relates to what drives this option-implied level of valuation. Much like a stock or bond, there are fundamental estimates of value (in this case, a volatility forecast) but also different opinions and levels of demand in the market. Some investors prefer one convertible bond to another and are willing to pay up to hold a position. Yet cheap—in the context of option-implied valuation, doesn’t always mean unloved or unwanted. What we know as convertible bond investors is that markets that trade cheaply also tend to offer better convexity, where the expected upside is greater than the expected downside for an equal move in the underlying stock.
In its simplest form, the answer depends mostly on the price of the underlying stock compared with the strike/conversion price of the option itself.
There are three states that we can review for an individual convertible bond:
Our preference as directional, long-only investors is for the second type of convertible. They offer the most convexity, meaning a positive ratio of upside participation versus downside risk for an equal move up or down in the underlying stock. Our portfolios are structured to give this balanced profile so that investors get equity-like returns along with bond-like protection.
The first type behaves more like a bond simply because the underlying stock price is very far away from the conversion price. As a result, small moves in the underlying stock won’t affect the price of the convertible, given that the option is a very small component of the overall price. Or, to put it another way, the convertible is trading on its bond floor, with limited equity sensitivity. This type of convertible is also more sensitive to factors affecting bonds, such as duration and credit.
The second type of convertible is trading above its bond floor, but not too far away. The reason why these bonds have convexity is that the convertible should be protected on the downside by reaching its bond floor value, while for a move up in the underlying stock, the conversion option will gain in value, although not initially at the same rate as the stock is moving upwards.
Finally, the third type of convertible is trading well above its bond floor, with an almost full participation to moves in the underlying stock that drives most of the changes to the convertible bond’s price. While this sounds attractive for stocks that continue to trade higher, a sharp move to the downside would cause the convertible to fall in-line with the stock, with the bond floor a long way further down.
We very much understand the reasons why investors want to understand the liquidity available in our market. After all, convertibles are a smaller subset of the broader corporate bond markets. And while it has been a decade since the 2008-2009 period, it is true that convertibles were affected badly at that time from the forced deleveraging of hedge fund strategies.
Let’s look first at the size of our market and note some of the trends that we have witnessed for issuance of convertible bonds.
2020 saw the highest amount of primary issuance of convertible bonds in more than a decade. This marked a big departure from quiet conditions for convertibles during the 2010s, where low interest rates and low volatility led many issuers to the straight debt markets instead. According to Refinitiv, the global convertible market was less than $400bn in size as of 2016. But with the return of volatility and the unprecedented conditions forced by the coronavirus pandemic, our market has grown past $670bn in size as of March 2021. We have found that growth of the market has been helpful for liquidity, with more bonds to trade and a broadening of sector representation.
Let us turn now to what happens once investors such as ourselves buy a new bond for our portfolios. We are commonly asked at what point we would sell a convertible, whether we ever intend to convert, or what happens if the underlying stock falls in price.
The answer is that there are more than a few preferred habitats for different types of investors that use our market, and that helps us with liquidity. By contrast, while it is true that broad equity and credit markets can see inflows or outflows based on asset allocation decisions, there are separate groups of investors managing either stock or bond portfolios only. Rarely will an equity investor sell stock to a bond fund, or a credit investor buy stock in significant size for their portfolios.
Below are some examples using the three types of convertible that we have mentioned:
We tend to see more crossover investors from fixed-income markets with interest in out-of-the money convertibles. This group of investors allows us to sell positions that have limited equity optionality, particularly if they are positive-yielding or offer value in credit versus the issuer’s other straight bonds. Also, it is often the case that a convertible with an out-of-the-money conversion option has kept its credit strength, even if the underlying stock price has fallen. That means even investment grade investors can buy convertibles that have out-of-the-money options. We do see instances of stressed or distressed convertibles, which have their own specialist investor bases, but our hope is that we have exited these positions long before credit become a problem.
For at-the-money convertible bonds, the main base of holders tends to be dedicated convertible investors, or market-makers looking to facilitate trades. We find that there are enough differences of investment opinion to make for an active secondary market. Also, there have been few passive strategies or vehicles launched to date; flows in and out of these funds have affected liquidity for other markets. In fact, flows often happen within our market, where one convertible-focused fund is looking to invest inflows that are a result of disinvesting from another investor, who then needs to sell. We have found that the flows among long-only convertible investors have been absorbed in an orderly manner, for the most part.
When an underlying stock performs very well, making the convertible an in-the-money option, these more equity-like convertibles become more appealing to relative value investors. This set of buyers includes both hedge funds and market-makers, who want to extract options from the convertible that they believe will become more valuable with volatility. If our market was composed of mainly long-only investors, it would be a potential struggle to sell out of winners, should no other investor want to hold an equity-like convertible with low convexity. But the presence of relative value investors allows long-only investors to sell out of winners and redeploy into more at-the-money convertibles, which tend to have more convexity and better suit directional investment strategies.
Finally, let’s re-examine what caused the forced sell-off of convertibles in 2008-2009 and estimate the likelihood of these conditions returning.
At their peak, hedge funds and other leveraged investors (including proprietary trading arms of banks) were holding roughly 75% of bonds in the convertible market. Then, banks came under stress and needed their prime brokerage divisions to call back credit that had been extended to these leveraged strategies. As a result, the unwind of the leverage needed to sustain these relative value positions meant that most investors in convertibles were forced to sell, but there were few natural buyers on the other side of their trade.
What changed in 2009 was that long-only, unleveraged convertible investors became the main holders of convertible bonds. After the forced selling of levered convertible strategies, the convertible market cheapened massively, and new allocations came instead to long-only strategies, which got the existing benefits of convexity along with an extra discount. We see this trend as here to stay. In many ways, we see a useful symbiosis between the stability that comes from allocations to long-only strategies, while still allowing for opportunities for relative value investors.
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