Convertibles Have Turned Into Equities
What convertibles' move toward unitary delta and zero gamma means to investors.
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.
This is what happens when the sweet smell of bull market success gets left out in the sun too long.
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