Are convertible bonds really attractive? Alain Eckmann, CFA International Investment Italian Forum November 8th, 2007
Table of Contents SECTION 1 Convertibles an attractive investment!?2 SECTION 2 The global convertible bond market5 SECTION 3 Will convertible bonds stay attractive?9 SECTION 4 Conclusion18
SECTION 1 Convertibles an attractive investment!?
Attractive risk/return attributes Global convertibles hedged in EUR 1994 – 2007 * Internal calculations Past performance is no guarantee of future trends. Source: Datastream, Bloomberg, UBS. Data as of August 31, 2007.
But is the future always like the past? Unfortunately asset allocation is more complicated than that Average return from March 2000 -8% p.a. Average return to March 2000 35% p.a. Nasdaq Composite Index 1994-2007
SECTION 2 The global convertible bond market
Global Convertible Bond Issuance 1995-2007 Growing global issuance, but with mixed regional themes Source: UBS AG, MACE Advisors. Data as of August 31, 2007.
Global convertible bond universe size Region USD billions Number of convertible bonds US 312 1 050 Europe 153 428 Japan 62 351 Asia ex-Japan 62 555 Other 24 183 Total 613 2 567 Source: UBS AG, MACE Advisors. Datas as of December 31, 2006.
Global convertible bond sectors Source: UBS AG, MACE Advisors, Datastream. Datas as of December 31, 2006.
SECTION 3 Will convertible bonds stay attractive?
Convertible bonds give exposure to… • Equity markets • Credit markets • Interest rates changes • Volatility changes Exposure to all these factors can also be taken on a stand alone basis But The convertible bond asset class offers more than the sum of the above and has therefore a very attractive risk/reward profile
Main performance drivers of convertible bonds More than the sum of classical performance drivers Convertible bond Bond content Equity content Prospectus Duration exposure Credit exposure FX exposure Volatility exposure Equity exposure Issuance behaviour & valuation Correlation
Equity markets versus convertible bond implied volatility* 50 350 Average implied volatility 45 40 300 Wealth Index 35 30 250 25 20 200 15 10 150 5 0 100 19/05/2002 19/08/2002 19/11/2002 19/02/2003 19/05/2003 19/08/2003 19/11/2003 19/02/2004 19/05/2004 19/08/2004 19/11/2004 19/02/2005 19/05/2005 19/11/2006 19/08/2006 19/05/2000 19/08/2000 19/11/2000 19/02/2001 19/05/2001 19/08/2001 19/11/2001 19/02/2002 19/08/2005 19/11/2005 19/02/2006 19/05/2006 UBS Convertible Bond Index - Eurozone (EUR) Average Implied Volatility (LHS) MSCI EMU (RHS) Source: UBS AG, MACE Advisors. Datas as of December 31, 2006. * We refer here to the European market, as the longest-running time series of average implied volatilities happens to be available for this particular market (as proxied by the UBS Convertible Bond Index).
Why convertible bonds cannot be replicated • Bond as exchange property • Better investor protection in comparison to traditional options • Optionality for companies where there is no liquid option market • Recurrent value added due to suboptimal call exercises by issuers
Cheap issuance Average cheapness of US convertible bond new issues 4,50 4,1 4,00 3,50 2,92 3,00 2,51 2,50 2,3 Percentage of cheapness 2,06 2,00 1,69 1,50 1,26 1,00 0,50 0,00 2000 2001 2002 2003 2004 2005 2006 Source: Lehman Brothers Datas as of December 31, 2006.
Cheap issuance 35% 32,8% Equities Convertible Bonds 30% 26,6% 26,2% 25% 21,6% 19,8% 20% 18,5% 18,1% 17,8% Issuance as a percentage of Market Capitalzation 17,4% 15% 10,9% 10% 5% 2,4% 2,0% 1,7% 1,6% 1,6% 1,5% 1,4% 1,4% 1,1% 0,8% 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 New issuance as a percentage of market capitalization Source: SDC, Datastream, Lehman Brothers, MACE Advisors, UBS AG. Datas as of December 31, 2004.
Benefits of high borrow cost 18,00 17,80 17,60 17,35 17,40 17,16 17,20 16,99 Theoretical Value in USD 17,00 16,83 16,80 16,69 16,60 16,40 16,20 16,00 1,0% 2,0% 3,0% 4,0% 5,0% Annual Stock Borrow Theoretical value of General Motors $6.25 2033 for various levels of lending fees Source: Bloomberg. Datas as of December 31, 2006.
SECTION 4 Conclusion
Conclusion Convertible bonds are an attractive asset class • Recurrent value added due to under-priced new issues • Recurrent value added due to suboptimal call exercises by issuers • Very good protection of optionality against corporate actions (takeover, dividends) • Optionality often priced with high stock borrow which favours outright investors (as else it wouldn’t work for hedge funds) • Exposure to correlation (the bond value is the exchange property) • Can not be replicated with other asset classes • Attractive risk/reward • Convertible arbitrage a very successful hedge fund strategy
Attractive convertible bonds… might be something for you?
Alain Eckmann, CFA Senior Portfolio Manager Executive Director • Alain Eckmann is a Senior Portfolio Manager within the Asymmetric Portfolio Solutions team. He is responsible worldwide for the convertible bond capability within UBS Global AM, which he helped to build up. • Alain joined the Asymmetric Portfolio Solutions team in 1997. His responsibilities included managing and enhancing the capabilities offered (capital preservations, currency overlay, Dynamic Alpha), and developing tailored client solutions. • During his studies, Alain worked for a private bank in Geneva, dealing with quantitative questions in asset management. After graduation, he built up a risk-management/risk-controlling department at Julius Baer in Zurich, developing mathematical methods to quantify market risks (VaR, etc). • Alain is co-author of the publications Exotic Options: A guide through the jungle of financial innovations, and The benefits of convertible bonds and is a regular speaker at international conferences. In addition, he is a member of the Swiss CFA Society and of the CFA Institute. Years of investment industry experience: 13 Education: University of Geneva (Switzerland), dipl.
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