Convertible bonds: The best of both worlds?

Transcription

1 Convertible bonds: The best of both worlds? Understand. Act.

2 Analysen & Trends 2

3 Content 5 Convertible bonds 8 Convertible bonds as investments 9 The market behaviour of convertible bonds 11 Convertible bonds and other asset classes 15 What does the future hold for convertible bonds? Imprint Allianz Global Investors GmbH Bockenheimer Landstr Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn) Ann-Katrin Petersen (akp) Stefan Scheurer (st) Gregor Krings Data origin if not otherwise noted: Thomson Reuters Datastream Allianz Global Investors / AllianzGI_VIEW 3

4 Convertible bonds: The best of both worlds? Most of the time, potential investors have to choose between bonds and equities. Bonds, unlike equities, generally offer a fixed rate of return. Equities offer the prospect of higher yields, but are generally considered more risky. Until recently, government-issued bonds were considered risk-free assets. They generate a steady return potential until the maturity date when the principal is redeemed. That is why they are always in demand by investors wishing to set up a fixed-income portfolio. Before it matures, however, the value of a bond may rise when interest rates fall. It may also fall when inflation and interest rates rise, or if the borrower s solvency deteriorates. Therefore, the safety offered by bonds is relative. A listed company s share offers an investor the opportunity to become a co-owner. As a co-owner, the investor has a stake in both the company s risks and its success. Capital invested in shares usually offers much higher yields than bonds. By reinvesting most of the profits, the value of the acquired share increases year after year, and this profit growth translates into higher dividends. Over time, an equal initial investment in shares of a company s stock can yield profits exceeding those from its bonds. The market also offers securities with features similar to those of equities and bonds. These are called convertible bonds, or bonds for which the principal can potentially be redeemed in the form of shares issued in exchange. Depending on market trends, the price of a convertible bond will change in various ways. When the equity market rises and there is less demand for bonds, this price tends to behave like a share. When the equity market drops and bonds are in demand, it tends to behave like a bond. In a way, it is the best of both worlds (see graph 1). But what exactly is a convertible bond, and how does it work? In what respect might it be the ideal investment for the current market situation? 4

5 Graph 1: Performance comparison of convertible bonds since 1995 Performance of convertible bonds, equities and government bonds in Europe (since 1995) Exane ECI-Europe Convertible Index Datastream Equities Europe Total Return Index CGBI WGBI EU All Mats Total Return Index Source: Datastream; Allianz Global Investors Capital Markets & Thematic Research Past performance is not a reliable indicator of future results. Data as of May Convertible bonds 1.1 Definition A convertible bond is a bond issued by a private company. It thus falls within the category of private bonds, also known as corporate bonds, as opposed to government bonds. As such: it pays a regular coupon, it is redeemable at maturity and its market value fluctuates with changes in interest rates, i. e.: the risk-free rate, i. e. that of government-issued bonds, and the rate premium demanded by the market following any improvement or deterioration in the issuer s solvency. Convertible bonds feature all the characteristics of a classic bond, except for one: it is designed to be repaid in shares, under terms and conditions defined in detail in the issuing contract. When the conditions for it to be converted into shares are fulfilled in other words, as soon as the share price meets or exceeds the conversion price the convertible bond adopts the characteristics of a share. 5

6 1.2 Convertible bonds from an issuer s point of view Convertible bonds offer several attractive features for the issuer: 1. Favourable borrowing terms and conditions. Essentially, a borrower must submit to the lender s terms and conditions. Those required by the financial market are often less exacting than those from banks. When the bond is expected to be repaid in shares, however, the market may accept a lower coupon than that of a traditional private bond if such shares offer a significant potential for future price gains. 2. The dilution or distribution of profits and dividends over a larger number of shares is deferred. The bond will be converted to capital when the investments profitability as well as additional profits partially or totally offset or even overcompensate the increased number of shares. Impact from the capital increase on profit per share, and thus on the market price of the share, will be slight or even non-existent. 3. Conversion can be forced. The issuing contract may stipulate that the bearer must choose between redemption in cash or shares as soon as the share exceeds X % of the conversion price during a certain period prior to the maturity date. The issuer can thus convert its bonded debt and increase its capital early. 4. Recall rights. Some issuing contracts allow the borrower to buy back outstanding convertible bonds whenever the average price exceeds a set level, on a defined date or over a defined period. The same occurs when the price of the share at maturity does not reach the conversion price. The buyback price is thus higher than the issuing price to provide the investor with part of the payment he or she sacrificed in exchange for a potential gain on the shares to be received. By doing this, the issuer can avoid a capital increase because it is no longer necessary. 6

7 1.3 Convertible bonds from an investor s point of view Convertible bonds offer several advantages and a few drawbacks: 1. The investor can enjoy steady income, at times comparable to that offered by other products over the same period. On maturity, the investor is repaid at least the amount of his or her capital in cash or shares. 2. Anticipated high yield. On maturity, the share conversion affords a potential for gain that is all the more attractive once the shares have exceeded the conversion price. 3. In the near term, a low coupon. The yield of a convertible bond is lower than that offered by a traditional bond with a comparable duration. This is offset by a gain only if the share meets or exceeds the conversion price. Such an increase, though, is never certain. 4. The principal is not guaranteed. The bond price may drop before the maturity date if the market declines, long-term interest rates rise or the issuer s solvency deteriorates. If the issuer defaults by the maturity, the principal may not be repaid in full. 1.4 Conversion ratio The main characteristic of a convertible bond, when compared to other bonds, is that it is redeemed in shares at a ratio of X shares for one bond, as defined upon issuance. This ratio is adjusted to account for any capital increases decided after the issuance date. Share redemption is usually optional. The choice is the investor s or the issuer s, which then redeems the bonds at a price often higher than when simply repaying the principal. Assuming they have a choice, each party will choose bond conversion or redemption according to what is most advantageous after comparing: the value of the shares to be issued against the redemption value of the bond and the dividends payable on the shares to be issued against the coupons paid on the bond. If the value of the share is higher than the redemption value, the investor will choose to convert the bonds into shares. If the former greatly exceeds the conversion price, it will be in the issuer s interest to redeem the bond if it can, even if it means increasing the capital later at a higher price. Share redemption may also be mandatory. In this case, the bond is said to be a mandatory convertible bond. Since redemption is to take place in shares in any case, such a bond is much more a (deferred) stock than a convertible bond. 1.5 Convertibility and redemption Take the example of a convertible bond at a ratio of 1 to 1, issued at EUR 1,000 when the share is valued at EUR 800. The share price must increase from EUR 800 to EUR 1,000, or 25 %, before the bearer considers converting the bond into shares. As the maturity date approaches: if the share price is higher than the conversion price, the bond satisfies the conditions for conversion, and it behaves like a share; if the share price is lower than the conversion price, the bond will not be converted, but redeemed. While awaiting redemption, the bond price may fall below the nominal price if there are doubts in the market about the company s capacity to pay the coupon and redeem the principal. At that point, the convertible bond behaves like a private corporate bond. 7

8 Graph 2: Standard profile of a convertible bond The four traditional zones 140 High returns Bond Mixed Equity Value of the convertible Premium Equity Bond floor Value of the option Value of the bond Value of the equity For illustrative purposes only. There is no guarantee that any particular strategy will produce positive results. Source: Allianz Global Investors Capital Markets & Thematic Research 2 Convertible bonds as investments Meanwhile, the conversion option behaves like any other call option on a stock: As outlined above, a convertible bond is defined as a private (or corporate ) bond with a call option for its shares at a set price. The discount on the coupon accepted by the investor as compared to the market conditions thus corresponds to the value of the call option, known as a premium (see graph 2). This generally represents 10 % to 15 % of the value of the convertible bond at issuance. At the maturity date, the bond principal can be converted into shares. It is as if the bond is redeemed and the proceeds are used to exercise the call option at the price set at the time of issuance. the closer the trading maturity date, the lower the option value; the more volatile the share price, the more it gains in value; the more the issuer s share price exceeds the strike price, the more it gains in value as well. In a perfectly efficient market, the price of a convertible bond is equal throughout its life to the sum of the values of the bond and the call option. When the share price approaches the strike price, the convertible bond is at its most attractive: 8 The convertible bond adheres to the same parameters as any other corporate bond, such as: the risk-free rate, i. e. the yield on government debt with the same maturity (higher long-term rates push the bond price down while lower rates increase its value); the issuer s solvency. If the issuer s solvency deteriorates owing to a rating downgrade, for example, the bond will depreciate. Conversely, if the issuer s solvency improves, the bond s value will rise. If the share price goes up, the price of the convertible bond rises likewise. The more it rises, the more the convertible bond s performance matches that of the share. If the share price goes down, the convertible bond s price falls significantly less (see graph 3). Regular coupon payments and the redemption of the principal on maturity bolster the price of the convertible bond. Only if its fundamentals deteriorate and there are doubts about the borrower s solvency will the price of the convertible bond readjust below the share price. Then it becomes a high return bond (see graph 2, left column).

9 3 The market behaviour of convertible bonds Before choosing a convertible bond, the investor does not just evaluate the issuer s credit quality. The investor also studies the bond s sensitivity (known as delta ), meaning the impact of changes in the share price on the bond price: Sensitivity below 30 % means that the convertible bond price is not very sensitive to the share price. This makes the risk inherent to convertible bonds comparable to that of a bond, which is the case when the share price is significantly lower than the conversion price. Sensitivity above 70 % means that the convertible bond price is very sensitive to the share price. This makes the risk inherent to convertible bonds comparable to that of a share, which is true when the share price is significantly higher than the conversion price. Sensitivity between 30 % and 70 % defines a convertible bond as mixed (see graph 4). The more the share price rises and diverges from the conversion price, the more sensitive the convertible bond becomes. Graph 3: With equivalent credit quality, a convertible bond cushions a downturn in the equity market Convertible bond price a Mixed convertibles Zone of positive convexity Convertibles behave like pure stocks In a market downturn, the convertible bond loses less value (a) than the equity (1). Convertibles behave like pure bonds Bond floor 1 Share price For illustrative purposes only. There is no guarantee that any particular strategy will produce positive results. Source: Allianz Global Investors Capital Markets & Thematic Research Graph 4: The less sensitive a convertible bond is, the more it cushions a decline in the equity market Convertibles behave like pure bonds Convertible bond price a b Mixed convertibles Zone of positive convexity Convertibles behave like pure stocks Bond floor Declines 1 and 2 of the share price are equal. But the impact (b) of Decline 2 is weaker than that (a) of Decline 1, because in the meantime the convertible bond has become less sensitive. 2 1 Share price For illustrative purposes only. There is no guarantee that any particular strategy will produce positive results. Source: Allianz Global Investors Capital Markets & Thematic Research 9

10 The more the share price declines and approaches or falls below the conversion price, the less sensitive the convertible bond becomes. The investor is therefore interested in convertible bonds for the cushioning they provide if the share price falls, for their coupons which often exceed dividends and for their potential for future capital gains (see graph 4). A convertible bond s ability to follow the rise of the underlying share and to more or less remain free of its decline defines what is called its asymmetry or convexity. Depending on changes in long-term rates and equity markets, convertible bonds may encounter four market configurations: A decline in interest rates and a rise in equity markets. This is the most favourable situation. The bond gains value as interest rates fall, and the conversion option gains value with the rise in share prices. The price of the convertible bonds rises. This was the prevailing market trend in the United States and Europe from 1980 to Lower interest rates and a decline in equity markets, often observed during an economic and market downturn. With the decline in interest rates, the bond value goes up (unless the issuer s solvency deteriorates), but with the decline in share prices, the conversion option loses value. The convertible bond undergoes a relatively small decline and behaves like a corporate bond, the nominal value of which cushions the falling equity market and option value. This was the pattern observed in the two financial crises of 2001 / 2003 and 2008 / Rising interest rates and a decline in equity markets. This is the least favourable configuration, in which holding cash is the only profitable option. The bond loses value when interest rates rise, and the conversion option loses value with the decline in the share price. The price of convertible bonds declines. Over the last 30 years, this situation has not prevailed for any length of time. Although it has occurred in prior periods and may in the future. A combined rise in interest rates and equity markets, often observed during an economic and market recovery. As interest rates rise, the bond loses its value, but with the increase in share prices, the conversion option becomes more valuable. Under this scenario, the convertible bond behaves more and more like a share. 10

11 Graph 5: Relative performance of equities vs. bonds since Relative Performance of Stocks vs. Bonds* * Equities: Datastream Europe Total Return; Bonds: CGBI WGBI EU All Mats, Total Return Source: Datastream; Allianz Global Investors Capital Markets & Thematic Research Past performance is not a reliable indicator of future results. Data as of May Convertible bonds and other asset classes As mentioned above, the price of a convertible bond will change in various ways depending on market trends. When equity markets are on the rise and demand for bonds is decreasing, the convertible bond s price tends to behave like a share. When, on the other hand, equity markets drop while bonds are in demand, it tends to behave like a bond. How have convertible bonds behaved over the last two decades and in comparison with equities and bonds? Here is the outcome of our reality check: Graph 1 gives an overview of the performance of European equities, bonds and convertible bonds over the last 20 years. Although the performance on equity markets was strong overall in the 1990s, the 2000s were marked by a rough note, a downward trend and an unusual amplitude in stock exchange cycles. Based on the relative performance of equities compared to bonds since 1995, we have split up the last two decades into five phases (see graph 5). Three time periods were marked by a strong relative performance in equity markets namely 1995 to 2000, 2003 to 2007 and 2009 to the present whereas the periods from 2000 to 2003, dubbed the TMT bubble, and the 2007 to 2009 financial crisis were characterized by relatively strong bond performance. Overall, the behaviour of convertible bonds is consistent with the characteristics examined above (see graph 6): They show a relatively stable volatility (see note 1). It seems neither to follow the volatility of shares, which experience sharp gains from one period to another, nor that of bonds, which recede over the same period. Note 1 Volatility: measures (in %) the amplitude of an asset s short-term performance compared to its long-term performance. The more the price of an asset varies in the short term, the more volatile, and thus riskier it is. A monetary asset whose value increases every day by 1 / 360th of the overnight interest rate is the least volatile (near to 0 %) and the safest. 11

12 They tend to have a markedly lower volatility than that of equity markets. This was particularly true between 2000 and 2003 as well as during the financial crisis of 2007 to 2009, when equity markets fluctuated wildly. The volatility of convertible bonds represented only about one-third that of equity. Furthermore, convertibles have a close correlation with equity markets (on average, around 74 % across all identified market phases), which is not surprising as this is inherent to the nature of the product. Depending on the period observed, they have a variable correlation with bonds: The correlation was weakly positive (17.5 %) from 1995 to The decline in government bond yields led to the revaluation of bonds and equity markets alike. In this environment, convertible bonds correlated mainly with equity, which performed better. Since the turn of the millennium, the correlation of convertibles and bonds has become negative. Government interest rates have continued to decline, and the value of bonds has continued to rise. But beyond higher volatility, equity Graph 6: Volatility, correlations and performance since 1995 Years of strong relative equity performance Correlation Convertibles to equities Equities and bonds Conv. to bonds % % % % % % YTD % % 4.07 % Average % 5.73 % 1.44 % Yield Convertibles Equities Bonds % % % % % 2.98 % YTD 9.39 % % 5.47 % Average % % 6.15 % Vola Convertibles Equities Bonds % % 3.78 % % % 3.11 % YTD 7.84 % % 3.76 % Average 7.70% % 3.55 % Sharpe Ratio Convertibles Equities Bonds YTD Average

13 Years of strong relative bond performance Correlation Convertibles to equities Equities and bonds Conv. to bonds % % % % % % Average % % % Yield Convertibles Equities Bonds % % 7.26 % Indices used: Convertibles: Exane European Convertible Bond Index Bonds: CGBI WBGI Europe, all maturities, Equities: Datastream Equities Europe Total Return. Calculation as of May Volatility: We used the 250 days volatility (see note 1) Sharpe ratio (see note 2) % % 0.12 % Average % % 3.69 % Vola Convertibles Equities Bonds % % 3.07 % % % 4.93 % Average 8.48 % % 4.00 % Sharpe Ratio Convertibles Equities Bonds Average Source: Allianz Global Investors Capital Markets & Thematic Research Past performance is not a reliable indicator of future results. Data as of May 2014 markets have suffered a downward trend leading to a decorrelation of equities and bonds ( 15.5 % to 39.2 %). In short, convertible bonds have decorrelated with bonds because they have remained mainly correlated with equities. Importantly, with convertibles participating in upsides, downturns were less severe, i. e., convertibles provided cushioning in case of falling share prices By way of example, from 1995 to 2000, convertible bond performance roughly matched that of equities, which rose sharply. In , the downturn was much less severe thanks to the coupons paid. And lastly, a Sharpe ratio (see note 2) that was always more attractive than that offered by bonds was observed. Note 2 Sharpe ratio: measures (in %) the additional performance of an asset compared to the risk-free interest rate, taking its additional volatility into account. The higher it is, the more attractive the asset that it measures. Overall, convertible bonds delivered roughly equal performance over the two periods, supported by a significantly lower volatility than equities. 13

14 Therefore, between April 2004 and April 2014: An investor who included convertible bonds in his or her bond portfolio would have significantly increased the portfolio s profitability while, of course, substantially increasing the risk (see graph 7). On the other hand, an investor who included convertible bonds in his or her stock portfolio would have significantly helped to improve performance while reducing risk quite significantly (see graph 8). During this period, convertibles would have provided an equity investor with a particularly attractive risk-return trade-off. Graph 7: Convertible bonds improve the performance of a bond portfolio (based on data as of April 2004 until April 2014) 5,00 % 4,50 % 4,00 % 100% Convertibles, 0% Corporate Bonds Return (Annualised) 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 2.00% 0% Convertibles, 100% Corporate Bonds 3.00% 4.00% 5.00% 7.00% 8.00% Risk (Annualised Volatility) Each point corresponds to an additional weighting of 5% in convertible bonds. Calculation based on Barclays European Corporate Aggregate Index and Exane European Convertible Bond Index. Sources: Datastream; Allianz Global Investors Capital Markets & Thematic Research, Data as of Past performance is not a reliable indicator of future results. 14

15 5 What does the future hold in store for convertible bonds? Financial markets today are confronted with a moderate economic recovery. In the aftermath of a major financial crisis, they are characterized by: a number of risks that are restraining investors: a deleveraging process in the developed world that has only started, the possible return of inflationary tension and radical changes on the economic and financial front with the emergence of new powers; the lowest long-term interest rates in over 50 years, which could rise if business improves, public indebtedness keeps rising or inflation increases; and a private corporate bond market where convertible bonds are traded, which offers attractive interest rates, both in terms of absolute value and by comparison with the rates of government bonds. This is resulting in equity markets that are volatile and are probably more resistant to bad news thanks to their weak valuation, yet hesitant to take on the risk of a sharp rise. Graph 8: Convertible bonds improve the performance and reduce the risk of an equity portfolio (based on April 2004 unitl April 2014) 4,50 % 4,00 % 100 % Convertibles, 0 % Equities 3.50 % Return (Annualised) 3.00 % 2.50 % 2.00 % 5.00 % 0 % Convertibles, 100 % Equities 7.00 % 9.00 % % % % % % % Risk (Annualised Volatility) Each point corresponds to an additional weighting of 5% in convertible bonds. Calculation based on MSCI Europe and Exane European Convertible Bond Index. Sources: Datastream; Allianz Global Investors Capital Markets & Thematic Research, Data as of Past performance is not a reliable indicator of future results. 15

16 In this type of environment, three main advantages of convertible bonds stand out for the short and medium-term investor: their defensive nature in the event markets lose confidence again; their regular and attractive return; and their sensitivity to rising equity markets. Over the long term, caution may prompt investors to fear renewed inflation and the resurgence of long-term interest rates, which creates an unfavourable climate for equities and convertible bonds and exactly the opposite of the scenario that prevailed between 1980 and However, we do not hold this point of view: More inflation would facilitate equity revaluation as well as that of all the real assets to which they are linked through the holding of goodwill, various real estate, patents etc. We do not expect convertible bonds to behave in the same way as they have over the last 30 years, when they were marked by falling interest rates and strong growth in equity markets. But compared to equity markets, they offer a particularly advantageous relationship between risk and performance under most market configurations. Olivier Gasquet Even if sustained, a resurgence of inflation and long-term interest rates would remain moderate because growth could be slower and competition among the economic players could be fiercer than in the 1970s and 1980s. 16

17 Notes 17

18 Do you know the other publications of Allianz GI Global Capital Markets & Thematic Research Risk. Management. Reward. Smart Risk with multi asset solutions Smart Risk investing in times of financial repression Strategic Asset Allocation Managing Risk in a time of Deleveraging Active Management The New Zoology of Investment Risk Management Constant Proportion Portfolio Insurance (CPPI) Dynamic Risk Parity a smart way to manage risks Portfolio Health Check : Preparing for Financial Repression Financial Repression Shrinking mountains of debt International monetary policy in the era of financial repression: a paradigm shift Silent Deleveraging or debt haircut? that is the question Financial Repression A silent way to reduce debt Financial Repression It is happening already Bonds Duration Risk: Anatomy of modern bond bear markets Emerging Market currencies are likely to appreciate in the coming years High Yield corporate bonds US High-Yield Bond Market Large, Liquid, Attractive Credit Spread Compensation for Default Corporate Bonds Active Management The Changing Nature of Equity Markets and the Need for a More Active Management. Active Management: Can Capital Markets be efficient? Harvesting risk premium in equity investing. Strategy and Investment Equities the new safe option for portfolios? Is small beautiful? Dividend Stocks an attractive addition to a portfolio Changing World Renewable Energies Investing against the climate change The green Kondratieff Crises: The Creative Power of Destruction Infrastructure The Backbone of the Global Economy Demography Pension Discount rates low on the reporting dates Financial Repression and Regulation: A Paradigm Shift for Insurance Companies & Institutions for Occupational Retirement Provision IFRS Accounting of Pension Obligations Demographic Turning Point (Part 1) Pension Systems in a Demographic Transition (Part 2) Demography as an Investment Opportunity (Part 3) Behavioral Finance Reining in Lack of Investor Discipline: The Ulysses Strategy Overcoming Investor Paralysis: Invest more tomorrow Outsmart yourself! Investors are only human too Two minds at work All our publications, analysis and studies can be found on the following webpage: / AllianzGI_VIEW 18

19 Disclaimer Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Convertible securities involve the added risk that securities must be converted before it is optimal. Below investment grade convertible and fixed-income securities involve a greater risk to principal than investment grade securities. Bond prices will normally decline as interest rates rise. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors US LLC, an investment adviser registered with the US Securities and Exchange Commission (SEC); Allianz Global Investors Europe GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Hong Kong Ltd. and RCM Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan. 19

20 Allianz Global Investors GmbH Bockenheimer Landstr Frankfurt am Main June 2014