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Convertibles Have Turned Into Equities
What convertibles' move toward unitary delta and zero gamma means to investors.
Howard L. Simons     

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.
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No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

More From Howard L. Simons
Convertibles Have Turned Into Equities
What convertibles' move toward unitary delta and zero gamma means to investors.
Howard L. Simons     

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.
< Previous
  • 1
Next >
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

More From Howard L. Simons
Convertibles Have Turned Into Equities
What convertibles' move toward unitary delta and zero gamma means to investors.
Howard L. Simons     

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.
< Previous
  • 1
Next >
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

More From Howard L. Simons
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