The value of a convertible is determined by a bond component and the price of a call option. The bond value is equal to the sum of the redemption price and cash value of all prospective income flows (coupons). Among the factors taken into consideration when determining the levels of these variables are the credit rating, liquidity, the interest rate volatility and the maturity of the convertible.
Whether or not there is a put option, the right of the investor to return the bond to the issuing company at a specific moment in time against a previously determined price (above par) is also a factor influencing the ultimate value of the bond. This right, which in certain circumstances is attached to convertible bonds and can often be exercised earlier than the moment of redemption, effectively shortens the maturity of the bond and gives it a higher redemption value. The bond value thus rises and this in turn has an impact on the level of risk (lower) and effective yield (higher until the put date) of the bond. A lowering of the credit rating attributed to the bond (company) by the official bodies that assign credit ratings, on the other hand, has an impact on the rate of discount (higher risk premium!). The bond value diminishes.
Other factors are significant in determining the value of the call option, such as the price and volatility of the underlying stock, the (super) dividend and again the time factor. The greater the volatility of the underlying stock the higher the value of the call option (expected value rises) and thus also of the convertible. Conversely a fall in the price of the underlying stock has the opposite impact on the value of the call option and the convertible.

The two most common motives for issuing convertibles are the sale of shares by a company at a premium to the current market price and the potential to raise money more cheaply by comparison with a straight bond issue. With the first of these motives the company presents a scenario predicting a substantial rise in earnings per share, thus justifying the indirect issuing of shares at a premium. This avoids the immediate dilution of earnings per share associated with a ‘direct’ equity issue. The combination of these two elements (bond and conversion right) enables the company to offer to pay interest at a rate below the current market rate. As a result, the burden of interest payments on the profit and loss account can be lower at the end of the day than if a straight bond had been issued.
There are other motives for issuing convertibles. First there is the underestimation of the costs involved in issuing shares. The dividend is frequently regarded as the only cost item, and therefore the costs of instruments related to shares (in this case convertibles) fall somewhere between shares on the lower side and straight bonds on the upper.
A second motive is the relative invulnerability of the convertible (bond plus call option) to the risk of the underlying company. Larger operating risks lead on balance to higher interest charges for the company but a higher risk profile also prompts greater volatility in the underlying share price and this is beneficial to the value of the call option.
The third motive is inefficiencies on the financial markets, as a result of which warrants are often overvalued at the moment of issue on the basis of their expected high return and the associated high risk.
The volume of the market is of importance in two respects. First and foremost the market capitalisation of a potential investment class should have a minimum volume in global and regional terms. There should also be a reasonable rate of growth to ensure convertible bonds will in turn be redeemed in future. These two elements are important because for many investors liquidity is essential if they are to assess the value added of any investment. It is difficult to determine a precise bottom limit for market capitalisation. Based on empirical data we put this limit for global and regional levels respectively at $250bn and $100bn. The global convertible market currently has a market capitalisation of some $450bn. Regional breakdown figures and their development over time are shown in Table 1. The figures indicate that the condition of liquidity is met.
A second point of relevance is the average size of the bonds at the time of issue. Historically, it has often been smaller companies, generally with a high Beta, that sought to raise funds via convertibles. Much has changed in the past 20 years and in the US and Japan the average size of convertible bonds has risen. The percentage breakdown (market capitalisation) in Table 2 shows ‘large’ enterprises claiming a significant role on the market for convertible bonds. As a result, market capitalisation grew from $100m – $200m to over $1bn on average. Mergers and takeovers require companies to raise large amounts of capital and convertibles are often part of the financing package. Institutional investors are also demanding more convertibles and the recent growth of the convertible market has attracted hedge funds.
The European convertibles market allows investors diversification. Active investors can take up some 60% of the stocks included in the representative index Dow Jones Euro Stoxx 50 in their portfolios in the form of convertible bonds. This means index investors who have an equity index as a benchmark are in a reasonable position to emulate the European index with the help of convertibles.
In Europe, the potential for diversifying investments and this has been driven by Germany and France. In Germany financial institutions have used the ‘exchangeable’ to float equity holdings in other German companies via a back door. The German market has taken flight in a big way. The reason this instrument was used rather than normal convertible bonds lay in the legislation at the time. In France, convertible bonds became more popular in the 1990s. France has the largest convertible bond market in Europe with a 36% share in overall market capitalisation. Spain and Italy as well as a number of East European countries are now emerging and should become increasingly significant.

The last important factor is credit rating. Convertible bonds entitle their holders to convert the bond into shares in the issuing or another company under predetermined terms. Credit ratings are regarded as important in assessing straight bonds. Many institutional investors are confined under the terms of their articles of association to investing in assets with a high credit rating
In the past 20 years interest in the role of convertible bonds in asset allocation has been inadequate. We believe that is about to change in the next few years. The development of global convertible indices and the ability to break down these indices regionally enable institutional investors to include convertibles in strategic allocation studies for their investment portfolios. Our tables show adding convertibles to a bond portfolio will generate the most value added.
Returns from convertibles after adjustment for risk compares favourably with bonds and the degree of correlation between convertibles and straight bonds is relatively low. Convertibles provide investors with a specific guaranteed periodic flow of income, while the capital sum is protected up to the moment of redemption (barring exceptional positions).
The following analyses at regional level – focussing on the US, Japan and Europe – deal successively with risk, return and the correlation with equities and bonds (Tables 3and 4).
US: The market for corporate bonds is exceedingly well developed and has shown ebullient growth and many institutional investors have significant positions The study yielded the following results see tables 3and 4.
Return on convertible bonds compare favourably with those on straight bonds and that risk is considerably lower than that on equities. One explanation is that primary issues are frequently cheap. This holds true not only for the American convertible market but even more for the European and Japanese markets. There is a fairly high degree of correlation between convertibles and equities. This is due to the increasing significance of TMT sectors and their volatility. Correlation with bonds is 0.42, which means the bond component gives investors in convertibles a considerable degree of protection from a downward correction of share prices on the market. Adding convertibles to a portfolio consisting largely of bonds rather than equities is advisable.
Japan: The striking result is the negative yield on equities and the associated high standard deviation. Japan’s stock market ‘bubble’ was burst by the Bank of Japan towards the end of 1989 and the Japanese central bank subsequently raised interest rates several times in succession causing the stock market to go into free–fall. Some caution is therefore called for in interpreting the results of this study. As the Japanese convertible bond market is as mature as the US market, the same conclusions apply. Virtually no mandatory convertible bonds are issued in Japan, while by comparison with the US convertibles are seldom if at all called by the issuing company. From the corporate point of view, therefore, policy on early redemption is far from optimal in Japan. Bonds with warrants, lastly, are much more popular in Japan than in the US. The result on balance is correlation between equities and convertibles. The sharp fall in interest rates during a large portion of the period studied was the reason the annual price performance of bonds on average exceeded that of convertibles.
Europe: Here again the same arguments apply for Europe as were cited in the case of Japan. The argument that the market for corporate bonds is much less well developed than in the US again holds true very emphatically for Europe. The results emerging from the study are as follows.
Risk levels for convertibles and bonds over the period in question are very close to each other, while their respective returns diverge significantly. There is virtually no difference between the return on convertibles and equities for the years 1995 to 2000.
Is there any such thing as a free lunch? We don’t believe there is. First and foremost, the period over which the study was conducted for Europe is relatively short in statistical terms, despite the use of weekly data, and unquestionably so by comparison with the analyses for Japan and the US. However there are no representative convertible index or data series available dating from any earlier. Convertible bonds on the European market typically have a relatively short life of five to six years. The European government bond market has longer periods to maturity on average. After taking due account of movements in European interest rates over the period studied the maturity factor has a positive impact on the risk profile of convertibles (lower rho).
Share price trends in the period 1995 to 2000 (to 31 March) were beneficial on balance. The convertible bond market characteristically has a high delta or sensitivity to equity prices. Volatility on financial markets also intensified over this period. And lastly, only 80% of the European convertible market qualifies for designation as ‘investment grade’ i against 100% for the European government bond market. In short, the above facts explain the large difference in yield compared with straight bonds, but equally the marginal difference compared with equities. Here again the conclusion is warranted, as was already clear from the analyses for Japan and the US, that on the basis of the correlation between convertibles and bonds it is attractive to incorporate convertibles in investment portfolios consisting (largely) of bonds. This will result in an improved return on the portfolio as a whole, without any significant increase in risk.
According to Invetsment Credit Suisse First Boston, convertibles should be allocated a weighting of some 30% in a portfolio of European equities and bonds. Is this a realistic option? Before giving an answer, we draw attention to the fact that the period studied by CSBF is on the short side in statistical terms. In our view the conclusion drawn by CSBF is not a realistic option and the most important argument that presents itself is the fact that the European market and the worldwide market in convertibles still only have market capitalisation of $110bn and $450bn respectively. And the outstandingly good performance of convertibles should not be taken for granted. It relates after all to a period in which share prices showed a consistent upward trend on balance.

Finally the average value of outstanding convertible bonds simply does not provide institutional or private investors as yet with the same potential as applies in the case of straight bonds and equities. To our mind therefore, a strategic weighting of somewhere between 10 and 15% has much greater validity in many respects.
For the US a regression analysis indicates that the alpha for convertibles is 0.10% against 0.04% for long–term corporate bonds. The analysis shows that given the specific risk profiles of the two categories, both convertibles and bonds gave a better performance over the period in question.
From a tactical point of view it would have made sense for investors to maintain an above average weighting in convertibles. And given the current consensus on prospects for the American economy in the period ahead and the recent trend in long term rates and against the background of the current high valuation of equity markets, it can still be interesting for investors in bonds to retain an average or above average weighting for convertibles.
A similar regression analysis was carried out by Ibbotson Associates in the case of Japan. The alpha for convertibles in that period comes out at 0.24%, against 0.28% and 0.26% for long term government bonds and corporate bonds respectively. A strategic weighting in convertibles would certainly not have been out of place for the regression period in question. But one comment is called for. For many years Japanese insurers and pension funds had to comply with a 5–3–3–2 Regulation, amended in 1999. The parties in question were permitted to invest a limited percentage in domestic or foreign equities and in equities as such. The bulk of the institutions’ assets were therefore held in bonds and convertible bonds, which enjoyed the approval of the authorities as an alternative to equities. This regulation provoked strong growth, particularly in the 1980s, in the volume of the convertible market and the absolute number of outstanding bonds (including bonds with warrants attached). The problem therefore now presents itself that, against the background of the greying that is significant in this context in Japan and Europe in particular, insurance companies and pension funds have always invested too little in equities. Thus from a tactical viewpoint with respect to the prospective matching of assets and liabilities there would be more than sufficient justification for taking the maximum possible position in convertibles. In terms of return, risk as well as alpha of convertibles compared with straight bonds, nothing lies in the way of such a policy to our mind. An additional argument is the predicted albeit hesitant recovery of the Japanese economy. This will enable investors to reap the benefit of rising equity prices.
In the case of Europe a semi annual regression analysis conducted by Goldman Sachs results in an alpha for convertibles averaging 1.00. This is high but also quite understandable in light of the large number of issues, the rise in long term rates and the sharp fall in share prices up to June 1999 followed by increasing volatility on stock markets after September of that same year.
The argument of greying and past regulatory constraints on institutions with respect to investing in equities, already cited in this section for Japan, applies equally to Europe. The vigorous growth of the European convertible market, as well as the improved negotiability and high quality on average of convertible bonds provide investors still largely focussed on straight bonds with sufficient potential for overcoming the problem. Economic prospects for Europe are reasonably upbeat for the next few years. It is fairly reasonable to expect the convertible market to continue growing at an accelerated pace in the near future on grounds of phenomena such as deregulation–privatisation– liberalisation and the dissolution of all kinds of cross holdings of companies such as we are currently seeing in Germany, for instance, but in France too and again in Italy. All this will have a beneficial impact on the negotiability of the instrument under discussion. Taken together, these two factors give every reason to favour a maximum position in tactical terms.
Bearing the above considerations in mind alongside our talks with staff responsible for studying convertibles at reputable firms in the financial services sector, we arrive at the following conservatively formulated conclusions.
Convertibles have performed well in the respective periods studied by comparison with both equities and straight bonds. The risk of this investment class was lower than that of equities but higher than was the case for bonds. The degree of correlation with straight bonds is low, which means incorporating convertibles into an investment portfolio generates the greatest value added. From the tactical point of view it was and still is advisable at this juncture to maintain a higher than average (strategic) weighting in convertibles in portfolios consisting (largely) of bonds. This is valid for all three regions studied.
Jacques Grubben is head of research at Insinger Asset Management in the Netherlands

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