Published December 3, 2011
Lombard Odier Investment Managers believes that convertible bonds' asymmetric profile offers an attractive risk-reward proposition
By GENEVIEVE CUA
PERSONAL FINANCE EDITOR
HOW would you like an instrument that allows you to participate in an equity upturn but also pays a coupon which cushions your downside?
Convertible bonds (CBs) are a hybrid investment of equity and bonds. The instrument is not readily understood in the retail market. One such fund by a homegrown asset management firm was actually closed some years ago for want of assets.
But the asset class finds a ready audience among institutions and private clients. Nathalia Barazal, head of convertible bonds at Lombard Odier Investment Managers, believes that convertible bonds' asymmetric profile offers an attractive risk-reward proposition, especially at this time of uncertainty.
'It's attractive to investors to have one foot in equity and credit. You can participate in the equity story, not 100 per cent but there is a trade-off. You give up a bit of the upside and you get some protection. That's the beauty of convertible bonds.'
The firm launched its Convertible Bond Asia fund at end-2008, with US$50 million in assets. By 2010, assets had burgeoned to US$250 million. Its fund size is currently about US$750 million, thanks to strong inflows. It invests in Asia ex-Japan CBs.
The instrument at its most basic is a bond that typically pays a coupon, although some are zero coupon bonds. Embedded in the CB is an option that gives you the right to convert to equity at a specified strike price at some point in the future.
As a bond, it will be sensitive to factors that affect the bond market such as interest rates and credit spreads. The bond value provides a floor to the bond. But the option also provides a degree of sensitivity to the issuer's equity. In a bull market, the higher the stock price, the greater the value of the embedded option and the bond's sensitivity to the equity, so that at some point the bond will begin to behave almost like the stock. However, the conversion premium of the option - or, the cost to convert to equity - means that the CB will lag the stock .
In a down market, however, the CB's sensitivity to equity declines, and it behaves more like a bond. The bond value and periodic coupons act as a cushion, so that its decline should be less than the stock's. CBs' volatility is also significantly lower - the asset class's five-year rolling volatility is 10.9 per cent, compared to 25 per cent for equities.
The catch, of course, is credit quality. Among high-yield or junk CBs, the correlation between equity and credit could actually rise in a downturn - that is, the stock price and credit quality deteriorates at the same time. In this case, you could lose more than you expected. As a form of risk management, Ms Barazal sticks mainly to investment-grade issues.
Against the backdrop of extreme uncertainty globally, CBs' values have dropped, signalling opportunities to those who have the appetite for some form of measured risk. The drop in value among Asian CBs has been significantly steeper than their European and US counterparts. Based on analysis by Bank of America Merrill Lynch, some 74 per cent of Asian CBs are cheap, against 59 per cent in Europe and 38 per cent in the US.
The relative underperformance of Asian issues reflects soaring risk aversion which has spurred a sell-off of risk assets and a flight to US dollar assets.
Still, the CB markets' drop this time around is not as severe as the 2008 crisis when the plunge in values was exacerbated by hedge funds' elevated leverage. At that time, the leverage factor was six times, says Ms Barazal, compared to today's 2.5 times.
'We've seen redemptions in the sector in August and September, but not as much compared to equity and fixed income. We're starting to see subscriptions . . . Companies are in much better health compared to 2008. They have healthy balance sheets and lots of cash. The drawback is they are not hiring or increasing capital expenditure.
'The yield sometimes offers a good carry and (the bond portion of the CB) may be cheaper than (the company's) debt, so it's very defensive, especially when you're not super-bullish on equities. Credit is still a good play. Even in a recession, corporates have the ability to pay the debt. It's also a good diversification from sovereign debt.'
Lombard manages roughly US$6 billion in CB portfolios, making it one of the largest CB managers. The funds are at the moment defensively positioned. The global fund is currently 16 per cent in cash compared to 20 per cent in recent months. The Asian fund's cash weighting was shaved from 16 per cent to 13 per cent. The funds typically can have a maximum cash weighting of a third of assets. They are not available for retail subscription.
'That high level of cash helped in the summer months. Everyone is happy, but having so much cash is not easy. Every day, we wonder - what can we do with the money? Where can it be deployed? Right now, cash is king. It's better to look at portfolio construction, at the smartest way to use every dollar by being liquid. Liquidity is something I factor in quite strongly.'
In portfolio construction, a benchmark is only a 'filter', she says. 'When I construct a portfolio, the first thing that matters is what do we think about the equity market, the credit market, interest rates, the global economy. How do we want to play it - with low equity sensitivity or high, through defensive stocks or growth stories. With this in mind, we find the best ideas and implement it.'
The global fund is overweight Asian names. For private clients, CB funds are positioned as a means to diversify a portfolio, with the potential to enhance returns and reduce volatility.
Meanwhile, Ms Barazal is optimistic about issuance. The credit crunch arising out of Europe may force corporates to consider capital markets for financing. 'Interest rates, I think, will stay low. But there is a new factor in terms of a credit crunch. Financiers have a smaller cake to share, so that means they will be very selective on whom they lend money to . . . We have the money and are willing to lend.'
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