Convertible bonds in ascension

 

Pension funds around the world are increasing their exposures or considering an entry into the convertible bond market as they try to take advantage of these underpriced securities. 

In the UK, Mercer has been promoting the strategy to its clients since the first quarter. Meanwhile, managers in the UK and the US say interest and flows from institutional investors, including pension funds, has multiplied since the start of the year. The industry has also seen pension schemes like the State of Oregon re-entering the market for the first time in years. 

“This is a market that is under priced,” said Mercer worldwide partner in London Nick Sykes. “A long term view is that you can get close to equity return with less downside volatility,” he said.

Those who moved in December or early this year scooped up convertibles at their most depressed levels after hedge funds were forced to shed these securities to meet redemption requests from clients. Despite the market rebound, experts in the industry still say opportunities exist. 

Convertibles are fixed income instruments that contain an option to convert to equity when the investor chooses to, or when the fixed income portion matures. Convertibles are typically issued with a lower coupon yield because of the valuable call option attached to it. They form a subset of the attractive credit market investors have been turning to as they put their cash to work. 

 In a letter to clients advocating the use of convertibles, Sykes wrote: “Convertibles can provide exposure where straight equity and debt securities are unavailable. For instance, they can be used to gain exposure to companies with no alternative debt securities. They also allow investors to draw comparisons of the potential between a company’s straight and convertible debt securities.”

 

Downside

The downside risk if the stock falls to zero, is typically the fixed income yield, said Advent Capital Management chief investment officer Tracy Maitland. 

The New York-based convertible bond manager said pension funds haven’t traditionally looked at these securities but he added that interest has started to pick up. He said anecdotally, the number of conversations he’s had with pension funds has increased five to 10-fold over the past year. 

“Most don’t do it yet…But it’s the beginning of people starting to look at something that is a traditional security that hasn’t been looked at in the past,” said Maitland. 

Morgan Stanley Investment Management convertible bond manager Davide Basile in London said their convertible long only strategy has more than doubled in assets since the start of the year. 

Morgan Stanley now runs US$900m, up from $400m at the start of the year. He said last year, the flows were coming from the retail and intermediary markets, whereas now, the bulk of the flows come from institutional investors. 

Data from Eager Davis & Holmes, a US-based consulting firm, suggest US institutional investors buy the argument for convertibles. The firm’s Tracker Hiring Analysis showed that investors placed 108% more assets into convertibles in the first half of 2009 than they did in all of 2008 and the last quarter of 2007 combined. 

The dollar amounts going into the niche asset class, however, are still small. 

Seven US investors, including four pension funds, placed US$325m combined with convertible managers in the first half of the year. This compares to three investors in all of 2008 placing $146m, and one in the fourth quarter of 2007 placing $10m. 

Eager Davis tracks publicly reported hiring activity, and as such, its data is often skewed to the more transparent activities of public pension funds. 

 

This year’s investors

Among those investing in 2009 was the State of Oregon Public Employees Retirement System. The pension plan hired Greenwich, Connecticut.-based AQR Capital Management in June to run a $150m convertible bond mandate. This is not Oregon’s first investment in convertibles. 

Office of the State Treasurer spokesman James Sinks said: “We had a portfolio for many years that was housed in our equity portfolio. It was terminated a couple of years ago because it was a drag on equity performance.”

He added: “This is a tactical move based on the distressed markets right now.” 

The San Francisco Employees Retirement System is just slightly overweight its target allocation to convertibles. The scheme’s target allocation is 5%, but is allowed to invest up to 10%, said deputy director for investments David Kushner. 

Its current investments range between 5% and 6%. Convertibles have been a part of the scheme’s portfolio for over half a decade.

In March, trustees at the pension fund earmarked $25m to Advent, but that has not been funded yet, said Kushner. 

“There was a significant opportunity last fall and the beginning of this year because of the dislocation in the markets,” said Kushner. “Hedge funds were selling their convertible holdings…and created a major dislocation in the market.” 

The fact that the value dropped so drastically shows that the downside protection doesn’t always work as planned, said Sykes, and a few factors led to their fall in value. 

Redemptions from hedge fund strategies forced hedge fund managers to sell their holdings at a discount to meet redemption requests, wrote Sykes in his note to clients. 

Meanwhile, short selling restrictions had made convertible arbitrage strategies harder to execute. Also, convertibles were often used as collateral and after the fall of Lehman Brothers, banks sold them at a discount to cover their positions, said Sykes. 

That combined with the dearth of credit in the markets made these a great deal. 

“Six to eight months ago it was in complete distress,” said Morgan Stanley’s Basile.

 

US results

The UBS Global Convertible Bond Index hedge to the US dollar finished 2008 down 31%. Year-to-date through the end of July, the index was up 26%.

By comparison, the Morgan Stanley Capital International World Index returned -38.3% in 2008, and was up only 13.04% in the first seven months of the year. 

The US dollar hedged Lehman Global Aggregate Bond Index returned 4.79% in 2008, and 3.77% in the first seven months of 2009. 

Despite a slight recovery, Basile said now is still a good time to get into the convertibles market. 

“We measure implied volatility of convertibles versus the volatility of the underlying stock, these two should be equal or the implied volatility of converts should be greater. Currently however implied volatility of convertibles in percentage terms is about 15 percentage points lower,” he said.

Still a discount, though not the 50 percentage points lower it had been in December. 

Now there is also more liquidity in the market which could make investors more comfortable with convertibles. 

“The issuance market has picked up,” said Basile. “(Globally), we were coming off of five months of practically no issuances until February or March.” 

According to data by UBS, globally, there was one issuance between October 2008 and the end of February 2009. There were 147 issuances in the following five months. 

 Convertibles fund manager at Aviva Investors in London Tom Wills said that in the UK, the convertible bond market is picking up after years of stagnation. 

“In the UK, we had very few issuances in the past ten years. Now there have been several just this year. That helps,” he said. 

Aviva convertibles manager Shawn Mato said that in 2008 “every primary market was closed”. 

“You couldn’t raise cash, you couldn’t buy stocks, couldn’t sell bonds…so the first ones out of the gate were the more high quality companies.” 

In June, the UK-based J. Sainsbury, owner of a well-known supermarket chain, announced a £190m convertible bond issuance with a five year maturity. The bonds have a semi-annual coupon of 4.25% and an initial conversion price of £4.1850. 

In May, the United State Steel Corporation announced a $750m convertible bond issue with a 4% coupon and a five-year maturity. 

Industry experts say the fact that more high-quality, blue chip firms have come to market, plays a small role in investors’ interest. 

 

Other investment avenues

But not everyone has been scrambling for a share of the convertibles market. 

Redington Partners founding partner Robert Gardner said: “From our perspective, our concerns are the depth of the market, what types of issuers come to the convertibles market and the composition of credit and equity risk.” 

“If you want to make an investment in an asset class, you want to see a number of issuers. Having blue chip names helps, but you want to see a couple of hundred for diversification purposes,” said Gardner. 

He also said investors are looking for more simplicity. 

“The greatest change in 2009 is that pension funds are looking at the merits of individual asset classes. This asset class has three components: credit, equity and equity volatility.” 

Despite having multiple components, the structure of the securities coming to market has been simpler than their predecessors, said Basile. 

“Issuance has been very vanilla whereas a couple of years ago you had more complex structures being issued,” he said. 

At least one investor has used convertibles as a way to dial down risk in its portfolio. Dutch pension funds manager Stichting Pensioenfonds ABP increased its allocation to convertibles, hedge funds and infrastructure by one percentage point each. Convertibles are now 3% of the overall portfolio. 

Spokesman Thijs Steger said: “These adjustments fit with the fund’s ambition to ensure more customisation of the structure of the investment process to the indexation ambition. In total, these minor adjustments result in a somewhat lower risk profile.”