WHITE PAPER CONVERTIBLE BONDS THE BEST OF BOTH WORLDS

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1 WHITE PAPER CONVERTIBLE BONDS THE BEST OF BOTH WORLDS Convertible bonds have become an increasingly popular asset class in recent years, as issuers and investors have gained an improved understanding of these complex and fascinating products. Today, their financial benefits and risk-reward profiles are again the subject of a lot of attention, and we aim in this report to explain their nature and their attractiveness as well as their role in a diversified portfolio. September 2015

2 What is a convertible bond (CB)? DESCRIPTION Convertible bonds (CBs) are fixed income instruments that give investors the option to convert them into a fixed number of the issuer s shares. When these securities are convertible into other issuer s shares, they are Exchangeable Bonds. Convertibles are hybrid securities: they combine the advantages of both debt instruments as they pay fixed coupons (typically lower coupon and yield compared with a straight bond) and will be redeemed at maturity at a pre-specified price and equity instruments due to the embedded conversion option that provides the investor with a participation in the upside potential of the underlying asset. In other words, the combination of the bond and the equity components will provide the CB with an enhanced upside potential, relative to traditional fixed income securities, and a capital protection or resistance to stock market corrections relative to traditional shares. DEFINING THE DIFFERENT TYPES OF CONVERTIBLE BONDS In Figure 1 below, the x-axis displays the underlying share price while the y-axis represents the price of the convertible bond. Parity represents the value that the investor would receive upon conversion of the bond. Typically, convertible bonds are issued in the central column (in the balanced area) with a conversion price that is 20% to 50% above the actual stock price. Until maturity, the convertible bond may move towards the right or left of the graph as its underlying stock moves up or down. FIG. 1 DEFINING CONVERTIBLE BONDS CONVERTIBLE BOND PRICE Busted Income-style CB Out of the money Balanced convertible bonds At the money Delta Equity-style CB In the money Convertible Bond Share/parity Premium Bond floor Conversion ratio SHARE PRICE Source: Lombard Odier. 2

3 Busted or Credit CBs A busted convertible security is trading well below its conversion value. The result is that the security is valued as regular debt because there is very little chance that it will ever reach the convertible price before maturity. Out of the money or Bond-linked CBs When the underlying share price trades significantly below the conversion price, CBs have low equity sensitivity and behave more like fixed income securities. The main price factors are the interest rate level and the issuer s credit spread. At the money or Balanced CB When the underlying share price trades close to the conversion price, CBs are considered balanced because of their asymmetric payoff profile. They have a medium sensitivity to changes in the underlying equity. The price factors are the share price performance, volatility movements, changes in interest rates and the issuer s credit profile. In the money or Equity-linked CB When the underlying share price trades significantly above the conversion price, CBs are highly sensitive to changes in the equity, whereas their sensitivity to changes in interest rates and/or credit spreads is low. These bonds trade at an insignificant premium or even a small discount to parity. Deep-in-the-money convertibles will almost certainly be converted into the underlying shares at maturity. WHO BUYS CONVERTIBLE BONDS AND WHY? The convertible bond market has been growing over the past decade, as both companies and investors became more aware of the benefits of the asset class. Today, the global convertible bond market has a total value of USD 443 billion and a universe of 2,300 securities (Source: Deutsche Bank, as of 31 August 2014). Different investors see the CB asset class through their particular lenses: Long-only investors including dedicated CB Funds The strategy is to generate above-average returns via capital gains and interest income while enjoying downside protection and lower volatility. We will illustrate in the second part of this report the attractiveness of the convertible bond asset class as a long-only investment. Studies show that convertible bond portfolios have outperformed traditional diversified portfolios in the medium and long term. The LO Funds Convertible Bond Fund is an example of a dedicated CB fund with a balanced strategy. Hedge Funds CB arbitrage is a typical Hedge Fund strategy. The arbitrageur is long a convertible and short the underlying shares according to the CB s sensitivity to its underlying (delta), in order to extract the convertible s cheapness. If the share price falls, the CB becomes more bond-like and declines less than the share price, so the trader buys back some shares. Similarly, if the share price rises, the convertible becomes more equity-like and the trader sells more shares. If it is possible to repeat this operation on several occasions, the trader will always be buying low and selling high. The hedge portfolio thus returns a profit under either scenario. Although this is not a risk-free profit, it is heavily risk-adjusted arbitrage, where the yield advantage of the convertible is extracted with very low risk. While the level of return appears small, the lack of risk allows hedge funds to leverage their investments. The percentage returns on the real capital employed can thus be quite large. 3

4 Equity and fixed income investors Equity investors will either buy deep-in-the-money CBs in order to retain full upside potential, or opportunistically switch out of the equity into a balanced convertible bond to retain upside potential while reducing downside risk. Fixed income investors tend to buy out-of-the-money convertible bonds that offer attractive yields, as was evident in the fourth quarter of 2008 and the first quarter of The added bonus is, of course, the upside participation in the underlying share. CURRENT MARKET CHARACTERISTICS Financial markets are at present characterised by low interest rates and likely rising equity volatility. The latter is a positive feature for convertible bond investors, who benefit from the valuable option embedded in the instrument. The yield-to-maturity of convertible bonds is relatively low however, reflecting the overall trend in fixed-income markets. Sector distribution in the CB universe is quite wide, with all sectors and sub-sectors of the MSCI well represented. Regional diversification is also clear, with 54% of existing issues coming from the US, 27% from Europe, 5% from Japan, 13% from the Asia-Pacific region and 1% from other parts (Source: Deutsche Bank). Credit quality runs the full spectrum of investment grade to non-investment grade. Today, between a quarter of the universe (in market value) is rated investment grade by one of the three main agencies with the remainder made up of both high-yield (28%) and non-rated issues (48%), which in a number of cases are of investment grade quality. (Source: BoA Merrill Lynch). New issuance is particularly important to the convertible bond market, as it helps to replace the outgoing converts and to rejuvenate the make-up of structures and sectors in the market. While the primary market was tepid from 2008 to 2012, recent levels of issuance (in 2013 and 2014) have picked up substantially. This is very good news for investors, since new issues bring diversification to the asset class but also fairer pricing (taking away scarcity premiums) and added asymmetry since new issues are typically the most convex profiles of the asset class. The health and attractiveness of convertible bonds are highly dependent on a dynamic primary market. From the investors point of view, it is important to note that synthetic convertible bonds have been widely used in the past to compensate for any shortcomings of the primary market and to diversify convertible bond portfolios. 4

5 Convertible bonds in a diversified portfolio COMBINATION OF DOWNSIDE PROTECTION AND UPSIDE PARTICIPATION Figure 2 compares the performance of the convertible bond asset class with that of equities, government bonds and cash since It clearly shows the last bull and bear markets and the potential of each asset class to appreciate on the upside and protect on the downside. The equity component of the CB the embedded call option explains its capacity to catch the upside whereas the bond component provides a capital protection in bear markets. Figure 2 illustrates that CBs are a much less volatile investment than buying common stock, but can provide the equity-like returns in bull markets (such as between 1995 and 2000 or between 2002 and 2007). They also offer strong downside protection in a bear market (such as the one experienced between 2000 and 2002). In the fourth quarter of 2008, the asset class experienced a sharp dislocation, as massive forced selling of CBs by hedge funds led to temporary depressed pricing (and very high yields). The correction of this dislocation led to the sharp appreciation of the asset class in the first quarter of 2009, as opportunistic investors made the most of the asset class cheapness. Over time, a convertible bond portfolio managed to take advantage of the asymmetrical profile of these securities offers investors the best of both worlds. They offer proven correlation to equities in good times and a safety net when markets correct, thus maximising volatility-adjusted-returns. FIG. 2 GOOD TO REMEMBER: CBS ARE AN ALL-WEATHER VEHICLE (AUGUST 2014) Aggregate Bond portfolio Cash Performance based on: Cash (1 month Libor), Aggregate Bond portfolio (JP Morgan Global aggregate bond index USD), Equities (MSCI World USD), Convertibles (UBS global convertible index USD). Convertible Bonds Equities 5

6 ILLUSTRATING FIGURES When looking at the performance of various asset classes over time, it becomes clear that investing in convertible bonds over the past three, five or ten years was much more profitable than investing in equities and, for most periods, also more profitable than investing in bonds. Furthermore, this performance was achieved with a fraction of the volatility. Over certain short periods, equities may outperform but the information and sharpe ratios of CB investors will be substantially higher than that of equity holders over the medium and long term. The sharpe ratio is a measure of risk. It measures the return above the risk-free rate in relation to the risk borne by the investor. FIG. 3 HISTORICAL PERFORMANCE AND VOLATILITY 3 YEARS 5 YEARS 10 YEARS EQUITIES BONDS CONVERTIBLES EQUITIES BONDS CONVERTIBLES EQUITIES BONDS CONVERTIBLES Performance 31.0% 8.3% 27.0% 80.8% 24.4% 77.8% 64.1% 67.2% 104.2% Volatility 15.1% 4.2% 8.1% 15.4% 4.6% 8.4% 17.5% 5.4% 8.9% Source: Lombard Odier (Equity: MSCI World [USD], Convertible Bonds: UBS Global Index [USD]). FIG. 4 PORTFOLIO ILLUSTRATION PORTFOLIO ALLOCATION Equity 50% 45% 40% 35% Bond 50% 45% 40% 35% Convertible Bond 0% 10% 20% 30% Increasing performance 10-year performance 65.7% 69.5% 73.4% 77.2% Volatility 11.5% 11.2% 11.0% 10.7% Decreasing volatility Source: Lombard Odier (Equity: MSCI World [USD], Bond: JP Morgan Global aggregate bond index USD, Convertible Bonds: UBS Global Index [USD] to ). Figure 4 above provides a simulation of an investor portfolio with four different allocations: the simulation begins with an equally-weighted portfolio between equities and bonds (an aggregate investment-grade index). We then gradually increase the allocation to CBs (by slices of 10%) to finally obtain a portfolio composed of 35% equity, 35% bond and 30% CBs. This allows us to compare the performance and volatility of each portfolio based on data observed from 2004 to

7 This simulation highlights that as we increase CBs allocation in the portfolio, the overall performance is greater and volatility lower: from the first (0% CBs) to the last portfolio (30% CBs), an additional gain of 10% is registered in terms of performance, whereas volatility went down almost one percentage point. Past performances show that CBs allocation makes sense thanks to the double advantage of the asset class: upside participation and downside protection, which materialises in an increasing performance within the portfolio and a decreasing volatility. We would therefore recommend convertible bonds as a very interesting asset class that at the very least helps money managers to diversify their portfolio. Why invest in CBs today? BECAUSE THEIR CURRENT CHEAPNESS REPRESENTS A CLEAR OPPORTUNITY The following chart aims to compare the effective price of the asset class to its valuation based on a sum-of-the-parts analysis (valuation of the fixed income instrument + valuation of the option). If these two valuations match, the convertible bonds will be situated in the centre. The instruments look increasingly cheaper as we move to the right of the chart and increasingly expensive as we move to the left. Currently, US and Asian convertible bonds appear quite cheap by this measure, while a portion of the European convertible bonds space is still expensive. Overall, the global market does not suffer from challenging valuations, especially when compared to other fixed income asset classes. FIG. 5 VALUATION OF CONVERTIBLE BONDS 50% 40% Asia Europe US 30% 20% 10% 0% >10% Rich 5%-10% Rich 1%-5% Rich 1% Rich - 1% Cheap 1%-5% Cheap 5%-10% Cheap >10% Cheap ASIA Expensive 4.7% 30.9% 36.9% Fair value 18.2% 48.2% 24.5% Cheap 77.1% 20.9% 38.6% EUROPE Expensive 8.0% 57.9% 57.5% Fair value 26.4% 28.8% 23.2% Cheap 65.7% 13.4% 19.3% US Expensive 34.1% 36.9% 30.9% Fair value 30.2% 28.8% 26.5% Cheap 35.6% 34.4% 42.7% Source: Lombard Odier, Bank of America Merrill Lynch, 31 August

8 BECAUSE CONVERTIBLES BROADEN INVESTMENT OPPORTUNITIES The diversity of convertible bond structures and their investment characteristics offer alternatives to meet a variety of investment objectives. Equity investors with a minimum yield requirement may be able to invest in a company through the convertible bond, as opposed to the common stock, while bond investors who cannot hold straight equity may be able to gain access to the company through a convertible. Fixed income investors wishing to add alpha (a return above that of their benchmark) to their performance may use convertible bonds to obtain equity exposure in exchange for reduced income. Furthermore, investors can use convertible bonds for quite different investment strategies, from the aggressive equity sensitivity strategy (through high delta, low premium, deep in-the-money CBs) to the total return alternatives (high gamma, balanced CBs), lower risk yield (short dates out-of-themoney CBs) or higher risk yield strategies (through speculative busted CBs). At a time of great economic uncertainty and volatile markets, it is clear that convertible bonds have much to offer investors. Indeed, whether we witness a genuine recovery, a return to recession or a soft (and jobless) recovery over the next few years, this asset class will allow investors to add return asymmetry to their portfolio. Directional investors will favor balanced convertible bonds of high credit quality in the case of a recovery, while lower-delta (and higher bond-floor) names will be the choice of bears. For those of us who are left perplexed by the current environment, convertible bonds are in fact an investment that allows our forecasts to be wrong, without our investments necessarily suffering. The best of both worlds indeed. Convertible terminology Straight bond value, investment value or bond floor is equal to the present value of the coupons and final redemption of the bond, i.e., the value of the bond portion of a convertible. Conversion price is the price per share at which a CB can be converted into common stock, i.e., the strike price of the option. Parity is the market value of the shares into which a CB can be converted, i.e., the value of the equity component (stock price x conversion ratio (/ exchange rate). It represents the value that the investor would receive upon exercising the conversion option. Conversion premium is the difference between a CB s price and its parity value. It can also be interpreted as the extra amount an investor must pay to own the same number of shares via the convertible. Delta is the equity sensitivity and represents the change in value of the convertible bond per unit change in parity (usually expressed as a percentage; e.g., a convertible with 50% delta increases in value by half a point if parity increases by one point). 8

9 FOR FURTHER INFORMATION PLEASE CONTACT Maxime Perrin Convertible Bond Product Specialist T E mj.perrin@lombardodier.com IMPORTANT INFORMATION This document is issued by Lombard Odier Asset Management (Europe) Limited (hereinafter LOAM). LOAM is a private limited company incorporated in England and Wales with registered number , having its registered office at Queensberry House, 3 Old Burlington Street, London, United Kingdom, W1S 3AB. LOAM is authorised and regulated by the Financial Services Authority (the FSA ) and is entered on the FSA register with registration number LOAM is part of the Lombard Odier Investment Managers Holding SA group (hereinafter LOIM ). LOIM is a trade name. This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This document does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. The contents of this document are intended for persons who are sophisticated investment professionals and who are either authorised or regulated to operate in the financial markets or persons who have been vetted by LOIM as having the expertise, experience and knowledge of the investment matters set out in this document and in respect of whom LOIM has received an assurance that they are capable of making their own investment decisions and understanding the risks involved in making investments of the type included in this document or other persons that LOIM has expressly confirmed as being appropriate recipients of this document. If you are not a person falling within the above categories you are kindly asked to either return this document to LOIM or to destroy it and are expressly warned that you must not rely upon its contents or have regard to any of the matters set out in this document in relation to investment matters and must not transmit this document to any other person. This document contains the opinions of LOIM, as at the date of issue. The information and analysis contained herein are based on sources believed to be reliable. However, LOIM does not guarantee the timeliness, accuracy, or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice. Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term United States Person shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income Lombard Odier Investment Managers all rights reserved. 9

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