05 December 2008

Hidden Opportunities in Convertible Bonds for Large Portfolio Private Investors

A real life example : Adecco - Switch into Convertible Bonds if you hold the equity.

Negative basis has engulfed the Convertible Bond market. In this context negative basis is the situation whereby the credit
spread on the cash bonds exceeds the credit spread being priced in the Credit Default Swap (CDS) market. Negative basis has
occurred in the Convertible Bond market for technical reasons relating to the traditional investor bases of hedge funds and
bank trading desks having their leverage cut and selling bonds ahead of investor redemptions or risk reduction within banks
to re-allocate scarce capital to more profitable areas.

For traders wanting to take advantage of this phenomenon with a two legged hedged position of long cash bonds and short
credit through CDS ( buying protection ) there are several reasons why this apparent free lunch still exists.

First of all Prime Brokers to hedge funds appear not to be willing to provide offsets in capital and margin between products
required to enter this trade ; making it an expensive use of capital. Secondly, buying credit protection provides no payoff in
the event of your counterparty ( i.e. an investment bank ) not surviving to provide you with the insurance you have
purchased.

What I am arguing for is not a negative basis arbitrage between cash and CDS but a simple opportunity for cash investors
to pick up yields on bonds far in excess of the “true” yield which would accurately price the risk of default. As an equity
investor, if you were willing to hold the equity of a company, you must in the majority of cases, be willing to take default
risk on a bond with a senior claim on the company’s assets.

Let me give a real-life live example of an opportunity for investors able to hold a position of CHF5,000 in one company
and still manage a well diversified portfolio. One of the companies I believe it makes sense to hold the convertible of is
Adecco SA. But first, let me put the investment case in context of the current economic climate.

With the US Labor Department announcing on 5 December the loss of 533,000 jobs in November , the largest monthly
drop for three decades, putting the US unemployment rate at 6.7% it only has to be a matter of time before the real effects
of this global downturn are felt in Europe to the severest degree. With the ECB for all too long fighting an inflationary
ghost their wake up call seems to have arrived but is possibly too late to avoid a severe recession across the Euro-Zone
even after cutting rates by 75 basis points on Thursday, 4 December.

As an investor you may feel that Adecco is, in the long run, a market leader and will survive the current downturn and that
a lot of the bad economic news is already priced into the equity. However, if this recession turns out to be longer, if not
deeper, you will see poor returns from this equity even if a dividend is maintained in some form.

If you hold Adecco equity in your portfolio it is time to re-assess holding the shares and instead switch into the 0% 2013
Convertible Bond, which with a par value of Chf5,000 and is currently being offered at 100.75% ( Chf5,037.5 ). This bond
has a put date on the 26 August 2010 whereby you can put the bonds back to the company at 110.98% of par ( Chf5,549 ).
This gives you an annual yield of 5.7% ( which is a spread of 472bps over risk free Swiss Government paper, or 442 over
swaps ). As a guide to the negative basis in this bond, quoted CDS to the full maturity date in 2013 is offered at 185bps and
to the put date in 2010 at 173bps.

Now your exit strategy to capture your excess returns with a negative basis trade is not necessarily to hold to maturity ( or
put date ). If the convertible market participants return ( and other types of funds not previously large users of convertibles
start to enter next year as seems likely to take advantage of this price dislocation) then this negative basis will erode more
quickly giving an instant pop in valuation.

In the case of Adecco, if the negative basis was to close to zero this in effect will lift the bonds by 4.5 bond points, a nice
return for effectively being a liquid investor in a technically troubled market which is not accurately pricing the credit risk
of the underlying companies but pricing its own insular troubles.