Investment Strategies

GUEST ARTICLE: Maitland Explores The "Lost Asset Class" Of Convertible Bonds

Greg Harris, Maitland, Senior Investment Manager, 18 June 2014


Today it is suggested that the investor base has changed significantly, with a much larger institutional (and unlevered) investor base that is less likely to be forced to close out positions during a stress event.

The attraction of convertible bonds in a market such as we find ourselves in today is that they share the positive characteristics of both bonds and equities – if equities go up, they will participate (to a varying extent) in the rally, and yet if equities fall they should experience the capital preservation characteristics of a traditional bond.

Much like equities, it is probably fair to say that convertibles are priced reasonably and that this is not an allocation without risk. However the very nature of a convertible bond, with its asymmetric payoff profile, makes it an interesting instrument to be exposed to at a time when there is much market manipulation by central banks in asset markets.

Convertible bonds benefit during times of significant equity dispersion as their convexity (increasing participation as equities rise) means that you will often make much more on your winners than what you will lose on the losers if you purchase them close to the bond floor. Instrument selection is important, but not as critical as for those in traditional equities.

M&A activity

Convertible bonds have an added complexity due to their embedded derivative nature, and many include clauses which protect the owners in the event of a merger / acquisition of the company. These terms vary by bond but can be massively advantageous to the owners of the bonds. In a world of increasing M&A these take-out premiums offer a further value enhancement strategy for owners of the asset class, provided you know where to look.

What is in it for the issuers?

Convertible bonds are attractive to CFOs who are able to keep their cash borrowing costs down (i.e. the interest rate they pay on borrowed money) by offering investors a "free" call option on their stock. Inherently this must lead to some biases within the convertible bond universe and cash-flush corporates who can raise money at very low rates in nominal bond markets are unlikely to be found issuing convertible bonds.

Investing in this market is a specialised activity and it would be difficult for an investor to build a portfolio of names without spending significant time researching the asset class, and understanding the intricacies of each issue. There are however a number of global funds with a variable focus on the asset class and a handful that are managed by boutique convertible bond managers that have focused solely on the asset class for decades.

A couple of basic truths never change irrespective of the asset class, that is don’t overpay for the underlying assets and understand what you are buying.

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