Convertibles Have Turned Into Equities

Howard Simons
  MAR 10, 2014 1:05 PM

What convertibles' move toward unitary delta and zero gamma means to investors.


Back in the days when Hollywood released more films than were nominated for Best Picture awards, society was struggling still with the "redeeming social value" standard for what was and was not considered obscene. We could apply the notion of redeeming social value to markets as well. Let's grant the two great bear markets of the past 14 years redeeming social value status for demonstrating what happens to convertible bonds during downturns and rallies.

As these bonds embed a call option on the equity to which they can convert, their delta or expected movement as a function of the stock price will fall toward zero when the stock price drops; these bonds are said to be "busted." Conversely, if the stock price moves well over the conversion price, the bond's embedded call option becomes deep in-the-money and the delta moves toward its limit of 1.00.

This has been especially true for high-yield convertibles, accessible via closed-end funds such as Calamos Convertible & High Income Fund (NASDAQ:CHY). If we map the total returns of the S&P 500 (INDEXSP:.INX) and the Bank of America-Merrill Lynch (NYSE:BAC) indices for high-yield and investment-grade convertibles on a common logarithmic scale, we see how high-yield convertibles have outperformed the S&P 500 for the past 21 years. More critically, the beta ore relative volatility of high-yield convertibles to the S&P 500 during the taper era has been very close to 1.00. The beta of investment-grade convertibles has been 0.923. Both markets' deltas are approaching 1.00.

A Lamentable Loss of Optionality
The inside story is this: The downside of this shared upside is that once convertible bonds start trading like stocks, that's as good as it gets. If the bonds’ deltas approach 1.00 and stay there, their rate of change as a function of the stock price, or “gamma” in option terms, approaches zero. Gamma is what gives options leverage on the upside and reduces losses -- subject to changes in volatility -- on the downside. As convertible bonds tend to be issued by firms with weaker balance sheets that hope to one day replace the fixed interest rate coupon of the bond with the variable dividend of the stock, convertibles' move toward unitary delta and zero gamma means investors are getting all of the potential downside of the potentially lower-quality associated equities and none of the leveraged upside of the call option.

This is what happens when the sweet smell of bull market success gets left out in the sun too long.
No positions in stocks mentioned.