Convertible bonds: perfect for treasure hunters and yield seekers
If you are looking to exploit the opportunities of equity markets and want efficient capital protection, investing in convertible bonds is an attractive alternative. Because the characteristics of convertible bonds can change very rapidly, investment director Martin Kühle advises professional management.
Convertible bonds are a fascinating instrument that offer a compelling set of characteristics for a number of investors,” notes Mar tin Kühle, Investment Director of the convertible bond team in Zurich. “Investors today generally want to benefit from the opportunities for return in the equity markets without being completely exposed to price risk. Achieving this kind of asymmetric risk profile elsewhere in the financial industry could involve multi-asset products or complicated risk limitation strategies. With convertible bonds, you have all this in relatively simple form in a single security.
Exactly how does it work?
Convertible bonds have two parts. First, they are a corporate bond with a coupon that a healthy issuer repays at its nominal value on maturity. Martin calls this the safety aspect of the asset class. The security also includes the right to receive shares in the company at a previously agreed price instead of repayment at nominal value.”This gives investors the opportunity for attractive returns if share prices rise.” As the price for this right, investors in convertible bonds accept a lower coupon. “If the price of the underlying shares goes up, the value of the conversion option climbs. At the same time, the value of the convertible bond also goes up. If there have been very significant price gains and it is clear that the convertible will be redeemed in shares, the price very often moves closely in line with the shares themselves,” Kühle explains. “However, if the share price falls, the value of the option also goes down – towards zero. Eventually the convertible bond drops to the bond floor, which is the pure value of a corporate bond without conversion rights.” From this point on, share price gyrations are irrelevant. Because even if the share price declines further, the investor still has the right to regular interest payments and redemption of the convertible bond at nominal value on maturity. A convincing combination overall, which sounds like a simple solution. “But in detail the investment is actually quite complex,” Martin sums up: “If you want to exploit the opportunities to the full, there are advantages to funds and specialised managers.”
Direct investments are difficult: Four good reasons for convertible bond funds
Direct investments in convertible bonds present four main challenges to most private investors. First, convertible bonds are often in large denominations of EUR 100,000 or more. The necessary diversification is not really possible without a fairly large account. Second, a position stands and falls on the long-term solvency of each issuer. Ultimately, the protective function of a convertible bond only works if the issuer avoids bankruptcy. “This is therefore a much more important factor in our choice of individual securities,” Kühle emphasises. Schroders’ eightstrong convertible bond team can also draw on the expertise of Schroders’ bond analysts. “If my colleagues come to the conclusion that over the next two years an issuer is in danger of default we rigorously winnow out the bonds in question.” Third, the bond conditions are structured very differently. This requires careful study of the prospectus and is another reason to leave the choice to specialists. But the fourth point is even more important.
“Actively managing a portfolio of convertibles means we can generate an additional return for investors,” Matin has found. Depending on the current value of the option, convertible bonds can be an aggressively or defensively positioned (see Figure 1). “We measure this using delta. The lower the delta, the more the convertible is similar to a bond issue. The higher the delta, the more the security behaves like shares in the company in question.” However, the price risk also rises with the delta, whereas with a low delta the share price has to rise sharply before the price of the convertible bond reacts positively: “Securities with a delta in the mid-range, between 30 and 70 per cent, are ideal – this is where our investors can best participate in rising equity prices while also enjoying the downside protection they want.”
Choosing securities actively and adjusting the portfolio appropriately keeps the risk/return profile of the strategy in the target area. “We are also therefore in a position to offer an attractive range of funds that are significantly different in their target returns and risk tolerance. Depending on the focus, convertibles that are more like bonds or more like equities take centre stage.” Asked about the current environment for convertibles, Kuehle is upbeat. Financial theory holds that the value of options rises as volatility increases, but this hasn’t happened in recent turbulent markets. “We are currently seeing inappropriate valuations of convertible bonds with many bargains. From a historical perspective, such market phases offer a good entry point.” Martin concludes: “Convertible bond funds should become even more attractive in the coming years.”
Convertible: our range of funds
Convertible bond funds can be very different in their orientation, so our solutions appeal to various types of investor with individual risk tolerances. Schroder ISF Global Conservative Convertible Bond is fundamentally positioned defensively and offers aboveaverage capital protection: “We are exposed only to companies with strong ratings. We want to capture around 60 per cent of the upside potential, but only 35 per cent of the bear phases,” Martin explains. Investors seeking greater upside potential with a greater risk tolerance could consider Schroder ISF Global Convertible Bond. This solution is designed to take on board around half of bear phases, but the stated target is also to exploit 80 per cent of the rise in equity value when prices go up.
*Schroder International Selection Fund is referred to as Schroder ISF.