Part 7

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• Part 7 Investors of convertibles Hedging and
  arbitrage
• Investors perspectives on convertibles
• Convexity ratio equity-like return with less
  risk
• Busted convertibles
• Hedging with stock and options

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• Investors who are restricted in their
• equity holdings
• Example Florida Department of Labor prohibits
  self-insurance funds from investing in any
  equities.
• Convertibles, despite their equity component,
  are
• typically classified as fixed-income
  instruments.
• These restricted investors will profit from the
  
• equity like payoffs available with
  convertibles and
• increase their diversification.

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Arbitrage specialistsThey attempt to lock in
profits due to misalignment between the equity
market and the convertibles. They are less
concerned with the positive outlook of the equity.
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Equity-like returns with less risk

• Convertible securities are an appropriate
  investment
• vehicle for long-term investors seeking a high
  rate of
• total return but with less risk than common
  stock.
• Convertible investors hope to earn two-thirds of
  the upside return with only one-third of the
  downside risk.
• - In bull markets, convertibles have trailed
  global
• equity markets by only a few percentage
  point
• - In bear markets convertibles offer
  considerably
• more downside support.

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• Convexity ratio
• Classic two-thirds upside, one-third downside
• Convexity ratio is the ratio of upside and
  downside participation.
• For example, suppose the convertible provides 64
  of the upside participation with only 34 of the
  downside movement, then the convexity ratio is
  1.85. That is, the convertible provides 85 more
  upside participation than downside risk.

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Insulation from volatility
The price movements of convertibles are generally
far less volatile.
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Risk-reward relationship Performance of various
asset classes, 1973-1995 Compound annual
return standard deviation Convertible bonds
11.70 12.47 SP 500
11.84 17.27 Long-term corporate
bonds 9.66 12.44 Intermediate-ter
m 9.91 8.93
corporate bonds Source Goldman Sachs Global
Convertible Research (1996) Convertibles as an
Asset Class.
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Possible reasons for the better performance
Inefficient company timing in calling
convertible issues If a deep-in-the-money
convertible enjoys a significant yield
advantage over the common stock but it is not
called, it is likely to outperform the
underlying stock. Companies may delay conversion
for a number of reasons including balance
sheet and rating agency considerations. Attr
active convertible pricing at issue Typically,
convertible securities are initially priced
several percentage points cheap to their
theoretical value in order to insure a
successful launch. The conversion option is
undervalued.
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What is a busted convertible? The underlying
stock is far out-of-the-money the convertible
trades on its fixed income characteristics.
Busted convertibles are characterized by low
equity price sensitivity (low delta), large
conversion premium and high yield to
maturity. delta lt 4 conversion premium gt
75 yield more than 10 Average credit
quality of the busted convertibles is BB- versus
BB for the entire domestic universe.
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Advantages In contrast to junk bonds, the
upside potential is not capped may enjoy
unlimited upside potential if the stock price
recovers. With busted convertibles, the equity
warrant (deep out-of-the-money) is often
mispriced. Investors are effectively buying high
yield debt with a free equity kicker. Busted
convertibles are more attractive investment than
high-yield debts in a modern economy that has
shifted from slow growth, cyclical companies to
more volatile growth companies.
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Disadvantages Busted convertibles are often
more illiquid. Traditional convertible investors
become sellers as equity sensitivity
diminishes. Convertible securities are
generally subordinate to other creditors in the
event of a liquidation or bankruptcy. The
biggest risk is continued credit deterioration.
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Arbitrage
The process of making a riskfree profit by
buying and selling the same asset in two
different markets simultaneously. Suppose the
convertible trades below parity, it can be
purchased while simultaneously shorting an
amount of stock equal to the conversion ratio.
This is a rare occurrence (may only occur in
markets where it is impossible or difficult to
short the stock). Recent market
phenomenon Volatility generally benefits
convertible bond arbitrage because a CB trade is
inherently long volatility, but it can also cause
problems if done without any delta hedges. For
example, in recent Indian market, the index
volatility shot up and some illiquid CBs
collapsed when the equity market fell.
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Hedging with common stock

• Undervalued convertible bonds present
  opportunity conservative
• investors can take advantage of through hedging
  techniques.
• Hedgers can retain a portion of the stocks
  potential by selling short
• a circumscribed quantity of common against a
  convertible while
• reducing or even eliminating stock market risk.
• They can swap upside potential for downside
  profits by shorting
• more of the stock.
• Carefully balancing the use of margin and
  hedging ratios can
• further enhance the risk reward relationship.

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Bullish hedges
Designed to allow investors to participate in
upward market moves at reduced risk. As an
alternative to owning the underlying
common stock, the hedge offers about half the
upside potential advantage while assuming a
small fraction of the downside risk. Bullish
hedges are a low-risk alternative to a mix
of stocks, non-investment grade bonds and cash.
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Example Bullish posture
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Bullish posture with 50 margin
The convertible bond may be purchased on
50 margin. The hedge positions upside
potential increases close to that of the
underlying common stock while limiting the
downside losses to only a fraction of the
commons loss. It is also a superior
alternative to owning the convertible bond
outright. If the common were to drop 50 in 6
months, the hedge position would be expected to
lose only 15 versus 30 loss for the
convertible bond.
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Example Bullish posture with 50 margin
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Example Neutral posture
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Hedging with put options
A short stock position can be created through
buying puts. The cost of purchasing downside
protection with puts is greater than the
accrued interest from the convertibles. This is
in contrast to the neutral hedge with stock,
which earns a positive stand-still of
return. As stock price goes down, since the
stock price moves down faster than the
convertible price, the gain from
puts accelerates. As stock price goes up,
once the put premium is recovered, the profits
increases.
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Example
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Hedging with less number of puts

• Buy 1,000 bonds at 118.57 and buy 50 puts
  struck at 100.
• Stock price change -50 -33 -16 0 16 33 50
• ROI (annualized) -4.8 -6.7 -6.2 -4.0 13.3 33
  .3 55.7
• Suppose we purchase only 55 puts for a hedge
  ratio of 62.5,
• this strategy
• reduces the loss on a stand-still basis
• permits modest losses on the downside
• increases returns on the upside

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• Long Stock Plus Long Puts
• outperforms on the upside, but provides little
  downside support.
• expensive to implement

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Hedging with shorting calls
Best scenario The stock price remains
unchanged and the option premium enhances the
income and reduces the initial investment. As
the stock price moves up, we get squeezed as the
loss on our short call position begins to catch
up with the premium earned, and the gain on the
convertible. On the downside, the premium
earned cushions the blow as the stock price
falls, but provides no real support.
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Example
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General strategies

• If we buy puts and pay a premium, we want the
  market to move.
• If we earn a premium by selling calls, we want
  the market to
• stand still.
• By buying puts and selling calls, we can
  combine the attributes
• of both.
• By altering the number of options and their
  strike prices, we
• can modify the return profile to match our view
  of the market.

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Long Stock Plus Short Calls
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Bond market volatility risk
Bond market volatility is harmful to convertible
hedgers Rapidly declining interest rates in
1992-93 encouraged many companies to call their
convertibles sooner than usual resulting
premature loss of conversion premiums and
accrued interest. Sudden interest rate up
trend in 1994 caused additional problems as
investment floors dropped. Declining interest
rates in the years following 1994 once again saw
an unusual number of convertibles redeemed.
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Risks of hedging Event risk
A bankruptcy may produce net losses depending
on if the bond winds up with meaningful
residual value. A cash takeover destroys a
bonds conversion premium. When a company
calls a bonds, it usually announces the
redemption just prior to an interest payment
date investors lose accrued interest in
addition to conversion premium.
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Choices of convertible bonds for arbitrage

• Speculative bonds lean more towards
  under-valuation than
• investment grade issues.
• Expected to hold up better on the downside than
  non-investment
• grade convertible preferred, non-investment
  grade convertible
• bonds make the best hedge candidates.
• A perfect hedge candidate is a high yielding
  bond trading near
• par at a modest conversion premium. It also has
  a volatile non-
• dividend-paying underlying stock that is readily
  borrowable
• for short selling.
• Convertible hedge funds generally leverage
  their investments.
• The level of margin is governed by Regulation T
  (50 maximum
• margin).