2 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.
3 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.
4 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.
5 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.
6 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.
7 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.
8 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.
9 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.
10 9. How did convertible bonds do in the financial crisis of ? 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 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.
11 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.
12 Thank you for requesting the booklet Top Ten Questions and Answers About Convertible Bonds Wellesley Investment Advisors specializes in one thing: convertible bonds. The professionals at Wellesley have been investing client funds in convertibles for over 20 years. Wellesley manages over $1 billion in convertible bonds for registered investment advisors, investment professionals, institutions, pensions, retirement plans, and high net worth individuals. The Wellesley Investment Advisors Convertible Bond Investment Program is offered through Halbert Wealth Management, an SEC Registered Investment Advisor. For more information, including a detailed performance summary, please contact Halbert Wealth Management at: Bee Cave Road, Suite 200 Austin, TX Before making a decision to invest, you should review all the important disclosures for the Wellesley Limited Risk Investing Program and make sure you understand all the risks involved. You should also review both Wellesley s and Halbert Wealth Management s Forms ADV, Part 2, which are available upon request. This investment involves the risk of loss and past results are no guarantee of future performance.
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