An Introduction to the Asset Class

Convertible Bonds

should the share price fall. In other words. This credit risk is expressed in the graph as the steep fall of the bond floor as well as the bond price on the left-hand side. Parity represents the value that the investor would receive upon conversion of the bond. On the other hand. if the share price falls. while the fixed income portion provides capital protection. the Convertible Bonds are worth the higher of (a) their redemption value (the price at which the issuer had agreed to buy the bonds back) or (b) the market value of the underlying shares. The conversion right provides the bond holder with a better-of-two-choices option. the embedded conversion option provides the investor with a participation in the upside potential of the underlying equity. On the other hand. Convertibles are fascinating hybrid securities. a Convertible contains the risk of the issuer not being able to repay the principal at maturity. The yellow line outlines the Convertible‘s fair value. the relationship between shares and bonds becomes more direct until the bond price behaviour and risk profile resemble characteristics of the underlying equity. the Convertible will participate in any increase of the underlying equity. The dotted diagonal expresses the intrinsic value called parity. they have the benefits of debt instruments that pay fixed coupons and will be redeemed at maturity at a pre-specified price. RMF focuses on Convertible Bonds priced in that area. . If the share price increases.DESCRIPTION Convertible Bonds (CBs) are fixed income instruments that can be converted into a fixed number of shares of the issuer at the option of the investor. On the one hand. the fair value of the Convertible Bond rises as well. Due to this call option. At maturity. Parity is a lower boundary for the price of the Convertible. The best risk-return profile is located in the red area where the Convertible’s potential upside is the greatest while the downside risk is relatively low. The level which will prevent the Convertible from falling further down is shown in the above graph as the bond floor (grey) which is also a lower boundary for the price of the Convertible. the bond‘s sensitivity to its underlying share price will decrease and the bond will not decline to the same extent as the equity. Bonds that are convertible into shares other than the issuer’s are called exchangeable bonds. a Convertible Bond is a straight bond with an embedded equity call option. As the share price increases. CHARACTERISTICS Payoff profile Yield Instrument Hybrid Instrument Equity Alternative ity Par rice rtible P Conve Premium Bond Floor Convertible price Stock price Source: RMF Research The x-axis displays the underlying share price while the y-axis represents the price of the Convertible Bond. Similarly to straight debt.

02 0.00 0.01 1.83 0.2 -0.4 0.00 0.5 164. Equity alternative (deep-in-the-money) Convertible Bonds where the underlying share price trades significantly above the conversion price are highly sensitive to changes in the equity.2 Share Price + 25% Equity Convertible Bond Share Price unchanged Equity Convertible Bond Share Price .0 0.5 4.19 0. which use the period 1976-2000.5 130 135 97. They have a medium sensitivity to changes in the underlying equity.5 135 120 130 130 135 130.90 0.36 0.) Investment Categories Yield instrument (out-of-the-money) Convertible Bonds where the underlying share price trades significantly below the conversion price have low equity sensitivity and behave like fixed income securities. and Real Estate which uses quarterly returns for the period March 1978-September 2000. Deep-in-the-money Convertibles will almost certainly be converted into the underlying shares at maturity.0 Cashflow 1.5 4.93 0. The majority of new issues are launched as balanced Convertibles.09 0.52 0. Hybrid instrument (at-the-money) Convertible Bonds where the underlying share price trades close to the conversion price are considered balanced Convertibles because of their asymmetric payoff profile.5 29. These bonds are affected by the share price performance and volatility movements as well as changes in interest rates and the issuer’s credit profile.0 -32. .00 0.00 -0.79 0.36 0.04 1. These bonds trade at an insignificant premium or even a small discount to parity. Source: Bloomberg Correlation Matrix for Convertibles and other major Asset Classes Convertible Large-Cap Small-Cap Bonds Stocks Stocks Convertible Bonds Large-Capitalisation Stocks Small-Capitalisation Stocks Long-Term Treasury Bonds Intermediate-Term Treasury Bonds Treasury Bills Long-Term Corporate Bonds Intermediate-Term Corporate Bonds Mortgage-Backed Securities Real Estate 1.CHARACTERISTICS (CONT.25% Equity Convertible Bond 164 Convertible Bond 162.28 -0.5 4. The main price factors are the interest rate level and the issuer’s credit spread.5 -15.00 0.00 0.91 0.00 0.93 0.32 -0.42 -0.02 Long-Term Treasury Bonds Intermediat e-Term Treasury Bonds Treasury Bills IntermediateLong-Term MortgageTerm Corporate Backed Real Estate Corporate Bonds Securities Bonds 1.25 0. Convertible Bonds can outperform pure equity and/or pure bond portfolios. whereas their sensitivity to changes in interest rates and/or credit spreads is low.0 97.00 Source: Ibbotson Associates and Goldman Sachs Correlations above are generally calculated using monthly total returns over the period 19732000.07 0.0 0.80 0.0 0.00 -0.23 1.07 1.3 0.16 1.30 0.0 1.51 0.12 0.00 0.97 0.34 1.95 0.35 -0.01 0.1 Share Price Source: RMF Research Source: RMF Research Global Performance across Asset Classes Value Index 250 200 150 100 50 Dec 94 Jun 95 Dec 95 Jun 96 Dec 96 Jun 97 Dec 97 Jun 98 Dec 98 Jun 99 Dec 99 Jun 00 Dec 00 Jun 01 Dec 01 Jun 02 ML-G300 Global Convertibles MSCI Global Equities JPM Global Bonds In the long run. The studies further show that CBs can replicate the upside movements of the share prices without the corresponding volatility.0 135. Price Behaviour of Convertibles Old Price 130 135 New Price 162. The exceptions are Mortgage Backed Securities.10 0.01 0.0 1.09 1.0 Capital Gain/ Loss 32.4 Total Return 0.51 0.00 0.5 120.92 0.14 0.25 1.4 -0.33 0.91 0.87 0.48 0.94 0.

the CB becomes more bond-like and declines less than the share price. the trader will always be buying low and selling high. while equities returned 9. The payoff of Convertible Bonds surpasses the returns achieved by either pure bonds or equities. The following map depicts the capitalisation of outstanding Convertible Bonds divided by geographic region (as of December 2001). their strategy would be to buy deep-in-themoney CBs. Fixed income investors Fixed income investors tend to buy out-of-the-money CBs that are trading with yields close to their corporate bond equivalents but contain the added bonus of upside participation of the underlying share price.CHARACTERISTICS (CONT.) (study by Jefferies). . Studies show that Convertible Bond portfolios have outperformed traditional portfolios (50% bonds and 50% equities) on a global basis from 1993 to 2000. The chart depicts the efficient frontier analysis of investing in bonds. Similarly. they enjoy the benefit of the embedded call option on the underlying equity as well as free downside protection. The arbitrageur is long a Convertible and short the underlying shares according to the CB‘s sensitivity to its underlying (delta). During this period.92% p. Europe USD 137 bn Asia (ex Japan) USD 29 bn Japan USD 91 bn North America USD 213 bn The Convertible Bonds Market: USD 470 bn Source: Merrill Lynch Market Participants 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.a. Equity investors As equity investors need or want full upside exposure. If it is possible to repeat this operation on several occasions. equities and Convertible Bonds. Hedge Funds CB arbitrage is a typical Hedge Fund strategy. in order to extract the Convertible‘s ‘cheapness’.) Efficient Frontier Market data indicate the advantage of investing in CBs as compared to fixed income instruments and/or equities. the Convertible becomes more equity-like and the trader sells more shares. Furthermore. they even outperformed pure equity portfolios (CBs returned 9. They could often generate an income advantage as the coupon yield is typically higher than the dividend yield. 0% B o nds 100% E quity ..07% p. 0% B onds 9% 14% Annualised Volatility 19% Source: RMF Research MARKET Global Overview The Convertible Bonds market has been growing over the last decade. if the share price rises. The data indicate this trend will continue in the future as both companies and investors become more aware of the benefits of Convertible Bonds. so the trader buys back some shares. If the share price falls.a. although that may be rather far away. 18% 16% Annualised Return 14% 12% 10% 100% B onds 8% 4% 100% CB s. The investors could also take advantage of in-the-money CBs trading at a discount to parity.

state-of-the-art models as well as good relationships to investment banks for access to new issues . or a blend of bonds and equities The successful management of Convertible Bond portfolios depends on various factors such as asset allocation.SUCCESS FACTORS The following factors are critical for the success of a Convertible Bond investor: Asset allocation skills because of the wide divergence between returns of sectors and countries over certain periods State-of-the-art models to keep up with the ever increasing sophistication of the other market participants Credit skills to assess the corporate bond-type credit risk Relationships to investment banks for access to new issues and stock borrowing (CB arbitrage) Market timing skills to protect the capital in extended phases of equity market weakness Risk management skills to avoid unwanted exposure to all types of risk including interest rate and currency risk Proprietary trading experience and mentality to take advantage of the relative value characteristics of the instrument SUMMARY In recent years. More and more companies are willing to look at the advantages of financing through Convertibles. We believe that this trend will continue and that this market will steadily gain significance in the future Convertible Bonds are instruments that are beneficial to both investors and issuers Convertible Bonds are an asset class with risk-return characteristics that are superior to those of pure bonds. pure equities. the Convertibles market has grown at an accelerated pace. security selection and credit skills. Convertible Bond funds or investment banks. and they find good demand from various investors such as Hedge Funds.

insurance companies. large corporations and distribution channels. with approximately USD 20 billion under management (excluding Real Estate and Private Equity). nor a recommendation to buy. Potential investors should note that alternative investments can involve significant risks and the value of an investment may go down as well as up. it does not assume any liability in the case of incorrectly reported or incomplete information. Such projections. specialising in Hedge Funds. Information contained herein is provided from the RMF database or obtained from sources that RMF considers to be reliable. sell or make an investment in the described investment instruments or to enter into or conclude other transactions of any kind. although RMF has taken professional care in gathering and updating this material and information.ch info@rmf. The information in this documentation is not intended for persons and organizations subject to U. As of 30 June 2002 RMF had funds under management of approximately USD 9. banks. however the Company also has physical presence in the major financial centres. such projections. This document and all information contained within is proprietary information of RMF and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from RMF. nor a solicitation. or investment and/or tax adviser. we recommend you consult your bank. CONTACT For further information please contact: Client Relations Team RMF Investment Consultants Huobstrasse 16 8808 Pfäffikon/SZ Switzerland Phone +41 (0) 55 415 87 10 Fax +41 (0) 55 415 87 94 www. federal. RMF was acquired by the Man Group creating the largest independent Alternative Investment Manager in the market. Focused on the institutional market. Past performance is never an indication or guarantee of future performance. state or local law or to the law of any foreign jurisdiction prohibiting the use or attention of this information whether on the basis of domicile. and one of the few organisations in the financial services industry to have achieved the ISO 9001: 2000 Certification for Quality Management Systems. In May 2002. RMF’s headquarters is in Switzerland. RMF commenced activities as an operative Hedge Fund Manager in 1992 with an exclusive mandate for one of the world’s most prestigious Market Neutral Hedge Funds. valuations and statistical analyses are provided to assist the recipient in understanding the basics of alternative investments. RMF has continued to focus on servicing investors by providing comprehensive products and solutions and is regarded as an innovator in the Alternative Asset Management Industry. nationality or for other reasons. nor an offer.RMF INVESTMENT GROUP RMF Investment Group is the leading provider of Alternative Investment Solutions. valuations and statistical analyses should not be viewed as facts and should not be relied upon as a prediction of future events. Leveraged Finance. The information provided herein is not intended to provide sufficient basis on which to make an investment decision. However. RMF is a process driven organisation.S.rmf. RMF’s target clients include pension funds. valuations and analyses may be based on subjective assessments and assumptions and may use one among several alternative methodologies (and other methodologies may produce different results). Furthermore. All projections. accuracy or correctness. Private Equity and Convertible Bonds. Over the years.ch 200/Q2_02 Disclaimer The content of this documentation is for your information purposes only and constitutes neither a request.5 billion. A member of the Man Group . Accordingly.

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