Minyan Mailbag - Convertible Bonds
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.
Pricing in converts may indeed be soft, but for outright convertible investors, like me, we are dramatically outperforming the underlying equities in our investments. Your statement neglects our investment class. Please try not to paint convertibles with such a broad brush. Outright convertible investing is NOT convertible arb and as an investment strategy is working quite well right now.
Minyan Brian Burkhart
Before the explosion of hedge funds, and particularly convertible bond "arbitrage" hedge funds, in the 1990's, convertible bond buyers were mostly straight purchasers of bonds. This is a class of bond investor that viewed the security as a bond first and an equity investment second. As a bond buyer, they are most interested in the certainty of coupon payments. Conversion into the common stock if the stock rose in price was viewed as an "equity kicker", a call option they are willing to pay for, but not all that much. There was little shorting of stock, at least until the stock rose significantly.
Enter hedge funds. As I have described in detail in other articles, convertible bond hedge funds are not willing to be "long" the stock through this imbedded call option. They instead want to only be long the volatility of the stock; consequently, they short stock immediately when they buy the bonds. As these funds grew in size and number, competition has forced them to price convertibles more richly. This class simply pays more than the previous class.
Convertible bond prices over the last six months have been influenced by two offsetting forces. Lower volatility has had a negative effect on prices, while lower credit spreads have had a positive one.
Hedge funds assume the volatility risk of the bond while they more often than not hedge away the credit risk. Therefore, they have suffered from the lower implied volatilities but not profited from the lower credit spreads. This led me to my short comment yesterday that convertible bond hedge funds this month were not doing well.
The writer is of the first class of investor. Because he does not short stock and does not hedge the credit, he has profited from lower credit spreads and as long as the stocks of the bonds he owns have risen even slightly, he has not incurred losses on lower volatility: the negative effect on the call price from lower volatility can be offset by only a slight rise in the stock price (delta effects are much larger than vega effects). Of course, the writer is exposed to lower stock prices: the coupon or interest earned offsets the losses from lower stock prices to a certain degree.
The writer as a straight convertible bond investor will outperform "arbitrage" hedge funds in a lower volatility market as stocks grind higher and credit spreads tighten. The writer will under-perform in higher volatility declining markets when credit spreads widen.
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