Document 6463823

1. What are convertible bonds?
Convertible bonds, most importantly, are bonds. They carry all the same promise of repayment
of principal and interest of all corporate bonds.
Unlike other bonds, though, convertible bonds (or simply “convertibles” or “converts”) give
holders the ability to participate in the upside of the issuing company’s shares. Investors in
convertibles have the right—but not the obligation—to convert their bonds in order to receive
greater value than the promised principal repayment.
Convertible bonds are not a new invention. They have been around since the 1800’s, when they
were used to finance the Internet of that era, the railroads. Today issuers of convertibles range
from blue-chips like Microsoft and Intel to much smaller and more speculative companies.
Convertible bonds have several defining features. These are:
Coupon (the promised annual interest rate)
Maturity
Calls and Puts
Conversion Ratio
Convertible bond coupons are typically lower than coupons of otherwise similar non-convertible
bonds. Investors accept the lower coupon because of the valuable option to participate in the
stock’s upside via conversion. This option is especially important when investors fear an
environment of rising interest rates. The possibility of upside can help shield convertibles from
the price erosion other bonds suffer in a rising-rate environment.
Some convertibles are simply issued with relatively short-term maturities, such as five years. In
these cases call and put options are usually omitted. Convertibles with longer stated maturities,
such as 20 years, are rarely intended to be outstanding for that long. These longer-dated
convertibles typically give holders several earlier opportunities to sell, or put, the bonds back to
the issuer, often at five-year intervals. With these bonds, the issuing company usually has the
right to call bonds away from investors, also often after five years.
The conversion ratio, specified in a convertible’s initial documentation, also defines a bond’s
conversion price. Most convertible bonds are issued in units of $1,000. A conversion ratio of 25
thus implies a conversion price of $40 (1000/25).
Conversion prices are typically set at a premium to the market price of the stock when a
convertible is issued. The premium is often in the 30-40% range but can vary depending on a
variety of factors.
Experience Drives Our Strategy.
2. Why should I be interested?
In a time of unprecedented low interest rates and high volatility, investors must reconcile their
need for income and growth with their understandable desire to protect capital.
Convertible bonds can be the solution.
A well-chosen convertible bond, bought at the right price, promises no worse than the full return
of the original investment, plus the opportunity for significant upside as long as the issuer
remains solvent.
With stocks, you’re always reliant on the market for liquidity. If you know you are going to
need a certain amount of cash in several years, it’s hard to depend on stocks. You don’t want to
have to sell into a down market, but you may be forced to.
Convertibles can greatly reduce your dependence on market conditions for your liquidity.
Instead of stocks, you can buy convertibles that mature—or can be put (sold) back to the
issuer—when you will need the money. As long as the issuing company is solvent, the money
will be there. And if the company has done well, you’ll be participating in much of the stock’s
upside.
How much of the upside?
The rule of thumb is that convertibles typically offer, in the medium term, two-thirds of the
upside of stocks with one-third of the downside.
But in the longer term, convertibles do even better. Studies have shown that convertibles
actually outperform stocks over extended periods, when you take both capital appreciation
and coupon income into account.1 Even more importantly, they do this while putting capital at
substantially lower risk.
To summarize, convertible bonds almost always provide:
Higher income than the underlying stock
Known return of principal
Lower volatility
Superior performance over time
There are plenty of good reasons to be interested.
1
Source: Bank of America/Merrill Lynch Convertible Research, March 31, 2012.
3. If I think a stock is going up, shouldn't I just buy the stock?
It’s true that on the upside, convertibles tend to underperform their underlying stocks.
This is because when you buy convertibles, you effectively pay a premium to the market price of
the stock. Think of it as buying insurance along with your stock. The insurance premium lets
you sleep better, knowing that in almost all cases you’ll do no worse than recoup par value for
your bonds. If you are disciplined about the prices you pay for convertibles, this essentially
means you’ll get your money back, even if the stock goes down significantly.
How much does the premium cut into your upside? A good rule of thumb is to subtract the
conversion premium from 100%. If you buy a convertible whose price reflects a 30% premium
to the stock price, and hold the convertible for an extended period, it’s reasonable to estimate that
you’ll participate in about 70% of the stock’s upside.
So, you may ask, why give up so much upside?
The answer is simple: while you may think the stock will go up, you don’t know that it will.
Some of your expectations may not pan out. Even if they do, the market may decide not to agree
with you.
Here’s another way to think about it. If you’re so certain a stock is going up, you probably have
a better alternative than buying the stock. You can potentially get a much higher return by using
options instead.
But, you say, with options you can lose everything if your timing is wrong, even if you’re
ultimately right about the stock.
Precisely. And if your timing can be wrong with options, it can be wrong with stocks as well.
We like to say that when you buy convertibles, you get paid to wait. You collect your coupons,
you take comfort in knowing that you’ll almost always at least get your money back, and you
wait for the stock to perform.
Remember that even though convertibles underperform stocks on the upside, they have
outperformed stocks over time. How can this be? Because convertibles outperform stocks on
the downside, and successful investing has more to do with limiting downside risk than
maximizing upside reward.
It’s been said that the wisest people are the ones who know how little they know. Investing in
convertible bonds makes uncertainty a lot easier to manage.
Experience Drives Our Strategy.
4. Can you explain the basic math of convertibles?
To understand convertibles, you just need to get comfortable with a few calculations.
One is premium. This is the amount by which a convertible’s price exceeds the value of the
shares it converts into. Bonds with low premiums offer almost as much upside as their
underlying shares. However, they are also subject to greater losses, because low-premium
convertibles usually trade well above the par value you receive at maturity.
In other words, bonds with low premiums trade at a higher prices—usually well above 100.
Higher-premium bonds, meanwhile, are associated with lower prices.
In other words: premium and price go in opposite directions.
Consider a convertible bond with a conversion ratio of 25, equivalent to a conversion price of 40
(1000/40), as we saw earlier.
You might see the convertible trading around 100 cents on the dollar (equivalent to $1000 per
$1000 face amount) when the stock is around 30. This represents a conversion premium of 33%
(40/30).
Another way to look at this is the bond, trading at $1000, converts into $750 worth of stock ($30
per share times 25 shares per bond).
Now let’s say the stock doubles to 60. The bond now converts into stock worth $1500 per bond,
or 150 cents on the dollar. Let’s say this is a relatively new convertible. It has a 3% coupon and
four years left until its maturity. The market price will probably be somewhere around 165 cents
on the dollar.
Where does the 165 come from? High dollar price converts usually are valued by the sum of
their conversion value (150), their remaining coupon income (3% annually for 4 years, or 12),
and perhaps a small amount of additional premium reflecting the assurance that you will get no
worse than 100 at maturity no matter how far the stock drops. (No matter how far, that is, as
long as the company remains solvent).
Note that 165 is 10% more than 150. So as the stock doubles, the bond’s conversion premium
goes from 33% to 10%. It’s now a very equity-sensitive bond that should participate in around
90% of the stock’s upside. But from this point, it will also participate in most of the downside as
well.
5. How and when do you convert the bonds?
One of the biggest misconceptions about convertible bonds is that investors should convert the
bonds as soon as the underlying stock exceeds the conversion price.
Actually, you only should convert when forced to—typically because the bond is maturing or
being called, with the stock above the conversion price. In other words, conversion only takes
place at the end of the bond’s life.
Otherwise, if you want to take advantage of the stock’s rise, you do something easier than
converting.
You sell.
The convertible market—especially hedge funds—will buy the bonds and pay an appropriate
price, the kind of price we saw in the last question.
Remember that if you convert bonds early, you only get their conversion value—the value of the
underlying shares. You give up residual value representing income the bonds will still generate
and insurance that the value will not drop, at the end, below 100 cents on the dollar.
Buying convertibles at the right price is the most important part of the process. But knowing
when to sell is critical as well.
Experience Drives Our Strategy.
6. Aren't convertibles only for hedge funds?
While it’s true that hedge funds are important participants in the convertible market, they are by
no means the most natural buyers of convertibles. In fact, most convertibles are better suited to
investors with far longer time horizons than hedge funds.
Here’s why.
Hedge funds specializing in convertibles are expected never to lose money. It’s completely
unrealistic, but that’s what most investors in convertible hedge funds expect.
At the same time, hedge funds, in order to generate attractive returns, need to use leverage.
Put these together and you have a recipe for the troubles hedge funds have every few years. As
long as convertibles behave the way the hedge funds’ models predict, everything is fine. But
once they begin to lag, hedge funds start losing money. Hedge fund investors—primarily socalled “funds of funds”—have no tolerance for losses and pull money out, leading to forced
sales, especially because hedge funds are using borrowed money and relatively small losses can
lead to margin calls.
What does this mean for long-term investors seeking to exploit the favorable risk/reward
characteristics of convertibles?
It means that you’re likely to experience occasional mark-to-market losses in the short term. The
good news is these losses really amount to buying opportunities. For investors intending to hold
convertibles longer-term, hedge funds actually add to the opportunity set.
Hedge funds buy high-dollar-price convertibles when disciplined investors look to sell (the
hedge funds, of course, hedge the convertibles by selling stock).
Hedge funds typically sell at depressed valuations when their investors are demanding liquidity
after a month or two of losses.
In both cases, hedge funds make it easier for true long-term convertible investors to profit
handsomely.
7. Why should I use a manager instead of buying convertibles directly?
In many ways, convertibles are the ideal asset for the individual. They provide the three
characteristics most investors want:
Return of capital
Current income
Upside potential
Why, then, should investors use a manager instead of simply buying their own convertibles?
For the minority of investors—those with the time, resources, and patience to choose and
manage their own convertibles—this may be a solution. However, there is still a major
difficulty. Retail investors generally are penalized when they trade individual bonds, including
convertibles, with steep transaction costs. Convertibles trade in a close-knit, relationship-based
market. Opportunities to buy and sell advantageously are largely reserved for the larger, more
active customers. This is particularly evident in the new-issue market. New issues are typically
sold somewhat cheaper than their fair value, and the ability to buy at the issue price is an
important source of returns.
In addition, institutional investors are better positioned to evaluate special offers sometimes
available to convertible holders—such as, puts, one-time reductions in conversion price and
inducements to extend maturities. While individuals and their representatives can manage these
situations, they may prefer to have more experienced convertible professionals handle them.
Essentially, while individual investors may want to consider buying convertibles on their own,
they may find it easier and more profitable to use an experienced professional convertible
manager or advisor. Qualities to look for when selecting a convertible manager or advisor
include:
Does the investment advisor solely manage convertibles?
Has the manager been managing convertibles for a long period of time?
Has the investment advisor managed convertibles over several market cycles (i.e. both
bull and bear markets)? It is easy in almost any asset class to make money in bull
markets, but good managers lose no or little money during bear markets.
Experience Drives Our Strategy.
8. What are the biggest risks in convertible bonds?
For long-term investors, the largest risk in convertibles is issuer bankruptcy. The beauty of
convertibles is that your investment can perform respectably even if the underlying stock does
poorly. But it’s still important to avoid catastrophes.
If you stick with profitable companies, and focus on convertibles whose issuers have plenty of
wherewithal to repay, you can generally avoid catastrophes without too much difficulty. Selling
just because the price is lower is not necessary: selling when the fundamentals have changed
significantly sometimes is.
For shorter-term holders, a wide variety of risks affect convertibles. In general the biggest and
most obvious is a decline in the stock market. Others include a general deterioration of credit, a
sharp rise in interest rates, and, in some cases, a decline in market volatility. Perhaps the most
important risk for short-term holders, such as hedge funds, is simply the presence of other sellers.
Few hedge funds have the long-term backers needed to withstand a falling market. Such
markets, however, benefit long-term holders committed to the asset class.
9. How did convertible bonds do in the financial crisis of 2008-2009?
Convertibles, particularly those issued by more speculative companies, experienced severe shortterm losses during the financial crisis. This was primarily because many hedge funds, which had
depended on Wall Street firms to lend them money for leverage, found their loans being recalled.
The only course of action was to sell, regardless of price.
This forced selling by hedge funds created opportunities the likes of which few long-term
convertible professionals had ever seen. Creditworthy issuers saw their paper trading with
double-digit yields and very modest conversion premiums. It was, in short, the opportunity of a
lifetime.
As markets stabilized in 2009, convertibles rallied back strongly to outperform stocks. The Bank
of America/Merrill Lynch V0A0 Convertible Bond Index was up 47% for the year while the
S&P 500 Total Return Index was up 26%. In this process, many longer-term investors that had
not been involved with convertibles took advantage of the forced hedge-fund selling. As a
result, while hedge funds continue to be a major force in the convertible market, they are not
nearly as prevalent as they were pre-2008.
The biggest lesson from the financial crisis is that while forced selling can take convertibles to
remarkably cheap valuations in the short term, the essential value of the asset class will reward
those who can stay the course.
Experience Drives Our Strategy.
10. What are the prospects for convertible bonds?
The zero-rate policy of the Federal Reserve, while enhancing the value of many existing
convertible bonds, has created a new set of challenges.
The new-issue market, a necessary source of convertibles, has been very slow in the low-rate
environment. Many companies that traditionally would have raised money via the convertible
market have been able to satisfy their requirements with non-convertible debt.
Having said that, many convertibles continue to offer the blend of current income, capital
preservation and upside potential that makes them unique, especially in volatile markets.
Moreover, a variety of circumstances are likely to bring about a return to greater convertible
issuance in the not-too-distant future. These include:
A fall in investor demand for high-yield bonds
A rise in the overall level of interest rates
Strong stock performance in certain industries
An increase in the level of market volatility
Convertibles have been around for over 150 years. While many so-called “experts” have
predicted their demise repeatedly, top ranking convertible managers have continued to
outperform equities and fixed income over full market cycles. They have proven resilient and
most worth buying at the low points of their popularity, many times at stock market tops.
We firmly believe long-term investors in convertibles will continue to be rewarded with
convertible bonds.
Important Disclosures: No content in this booklet should be construed as specific investment advice, or replacement for investment advice from
Wellesley Investment Advisors, Inc., or any other investment professional. This is not an offer to purchase securities. All investments, including
convertible bonds, have a risk of loss. Past performance is not a guarantee of future results.
© Copyright 2012 Wellesley Investment Advisors, Inc.
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Top Ten Questions and Answers About Convertible Bonds
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