Financial Journalist

FT Mandate 21 May 2001

Could convertibles push equities into the shade if understanding of them was more widespread? Examples of convertibles currently on the market show they can provide more security than equities, says Gerry O’Kane

“They simply will not see the opportunities available to them in the convertible market,” says Jeremy Howard, head of Deutsche’s global convertible research, referring to what he contends is the stubborn refusal of equity fund managers focus seriously on an investment instrument that combines the security of fixed income with the potential upside of an equity holding.

Any investor in equity funds should pay attention because, while the global convertible market has reached a market capitalisation of US$460bn, Mr Howard describes equity funds as “also-rans” in their use of them. As shares have plummeted in the past months, his argument for their use is a strong one: low downside risk while retaining exposure to the equity and usually receiving a higher yield.

The basics
Mr Howard is convinced that a failure to understand the basics of convertibles has been the reason and it disappoints him. While there may be complex issues involved in the market, certainly in the way hedge funds utilise them, they are easy instruments for an investor to understand. So much so that banks in Luxembourg pushed their customers to buy them in large numbers last year.

In their simplest form convertible securities are part debt and part equity.

The holder has the right (but not obligation) to exchange the bond for the underlying share. At maturity the holder can either get back their cash, having had the benefit of a yield over the convertible’s life, or convert to the underlying share, whichever option affords them the most value. There are exceptions to this basic model but essentially anything else is a variation on this theme.

“I would consider non-genuine convertibles to be securities structured by institutions which are linked to equities, an index or even oil prices which carry some form of financial guarantee,” says Mr Howard.

He is adamant that investors should be careful with related instruments called reversible convertibles. “They give you what looks to be very high yield, perhaps 13%, but the downside is that the redemption amount is linked to the stock price on the way down.” And with the current bear market, investors who are holding reversibles are suffering.

The Colt Telecom story
A look at several convertibles currently on the market can clarify what investors, retail, fixed income or equity should look out for.

Colt #3, issued in December 1999, was the third convertible Colt Telecom had released. It pays a coupon of 2% with a final redemption date in 2006.

Had an investor bought at issue in 1999, they would have paid Euros1000 for the right to either get back his E1000 in 2006 or to take 17�6065 shares (the conversion ratio). He would also have been paid an annual coupon of 2%. The pricing of the bond meant the investor was paying a 30% over the prevailing stock price (E56.80 versus E43.69)

Why might an equity fund manager have bought the convertible over the equity?

On the upside, although the premium of 30% meant the convertible did miss a little of the initial upside, the bond did capture a significant amount of the upside. The bond rose 30% to 130, while the stock rose 44%.

But over this short period the convertible was yielding slightly more. Almost 70% of the upside was a decent participation, considering the downside protection that was inherent in the convertible; downside protection that was to prove massively useful in the coming months.

By late March 2000, Colt shares were doing very well, with parity (the value of the shares underlying the convertibles) hitting approximately 120% (E1,200 per bond). This was an increase of about 40% in the share price. The convertible rose as well, by 30%. Not quite all the upside, but a good performance.

As the TMT wreck gathered pace through 2000, Colt Telecom stock was destroyed. Equity fund managers who sat on their stock saw their investment plummet 86% to the low in March 2001.

But the convertible’s performance was a different story. Although the creditworthiness of the company did suffer in the bear market, the fixed redemption price of the convertible effectively gave holders a put option on Colt Telecom stock. The convertible therefore, never traded below 72, a decline of only 44.6%.

So the pay-off profile was 70% of the upside but only 52% of the downside, a risk adjusted out-performance, and all the time the holder was receiving a higher yield. “So in a bear market the convertible lowers the downside risk, while retaining exposure,” says Mr Howard.

On a wider portfolio basis, such risk-adjusted performance is hugely useful in improving returns.

Credit quality lesson
There is also a lesson to be learned from the Colt 3 convertible and this is the bond element of the instrument.

“The credit quality of the issuer is important,” warns Howard. He says that, as with any bond, the amount of debt outstanding is important. In lower credit quality companies such as Colt Telecom, if the share price falls precipitously the riskiness of the company’s debt increases and the bond floor (that is value of the convertible as a straight bond) falls. This is what happened to some extent in the Colt example.

The Siemens/Infineon story
An example of a convertible that has avoided Colt’s problems with credit spread expansion, is Siemens/Infineon. This was what is known as an exchangeable bond. The only difference with an exchangeable it that it is issued by one company but converts or exchanges into the shares of a different company (usually one in which the first company has a cross-holding).

In this case Siemens was holding shares in Infineon following its partial IPO, and was releasing an exchangeable was a way of disposing of a further stake. What makes this product so attractive is that issues such as credit worthiness do not relate to the underlying stock but to the issuer, in this case Siemens. Any decline in the Infineon share price does not affect the credit of Siemens.

Mr Howard says, “Brought to market in 2000, the convertible offers a 1% coupon and, with an issue size of E2.5 billion, should also ensure good liquidity. The effect of having such a large firm guarantee the convertible is reflected clearly in the convertibles price performance, especially when compared to Colt.

“The convertible was issued at 100 and has never fallen below 90, a downside of less than 10% despite the huge fall in Infineon’s share price. Had you been holding Infinion shares over the same period you would have lost well over 50% yet had neither an annual coupon nor guaranteed repayment of your original capital.”

Flexibility on offer
“It should be remembered that convertibles are used for different reasons by different investors,” says Howard.

“At one end you have the Belgian dentist investing for income with a guaranteed repayment and the possibility of huge upside if the share performs well.

“At the other end of the spectrum sit some of the most sophisticated hedge funds in the world. They also use convertibles as arbitrage vehicles, performing a number of complex transactions to unlock theoretical undervaluation,” he says.

“While the use of convertibles in hedge funds is a complex story involving deltas, gammas and swaps, it is hedge funds that now keep the market efficient, by ensuring that convertibles trade close to their theoretical value in the secondary market. This is good news for all investors.

“When we are pricing convertibles, the valuation of the equity option component is very important for us,” says Mr Howard.

But away from the hedge fund community, his rules for investing in his asset class are simple: “Always pick an underlying stock that you like, this is the most important rule. Check that the credit quality is as high as possible and that the bond is not too close to maturity or an issuer call, and you will usually have an instrument that will perform well in all weathers.”

convertible bonds, equity funds