Archive for Asset Allocation

2009; The Year to add More Convertibles to your Portfolio?

Posted in Financial Markets, Manager Selection, Portfolio Optimization, Risk Management, Uncategorized with tags , , , , , , , , , , , on March 27, 2009 by evd101

By Erik L. van Dijk

The credit crisis was the period of disasters with structured products. Even the normally relatively quiet convertible  bond market ended up being bashed in the illiquid, panicky arena that financial markets seemed to be all through 2008 and especially since Sep/Oct 2008. Convertibles are basically hybrid securities with a risk profile somewhere between that of straight bonds and equities. On average, their expected return will lie between that of bonds and equities as well. Convertibles are hybrid in that they contain a debt component and a call or warrant component directly linked to the underlying price movement of equity. This implies that the holder can benefit from the upside potential of stocks, while at the same time having the debt value as a cushion.

Contrary to the situation in 2002, convertibles didn’t seem to provide investors the relatively soft-landing scenario they expected. On February 11, 2008 DJ Financial News Online stated that it would be an interesting year for convertibles, ”because they should benefit from the increased volatility”. Yes, it is true – and we know that from option models like Black and Scholes – that the call option or warrant component of this hybrid security will benefit from an increase in volatility. However, and that is the difference with regular options, the cushion component provided by the underlying bond might get hurt in that a period of increased volatility can often go hand-in-hand with economic debacle. When this became reality in 2008, the high correlation between volatility increases on the one hand and increased probabilities of default on the other led to a higher credit spread. This in turn triggered an increase in the relevant discount rate for the calculation of the net present value of the bond component of the convertible as a result of which the positive option valuation impact caused by volatility increases was more than offset.

And that is why convertibles are difficult securities. Only the true champions like for instance Nick Calamos of  Calamos Investments or Kris Deblander of Ed Rotschild Asset Management know how to add up the various valuation components that play a role in convertible pricing in the right way. In and of itself the pricing of convertibles is straightforward when looking at the individual variables that play a role in their valuation. Unfortunately adding them up is difficult because the relative importance of the various individual factors changes not just over time, but also when comparing one issue with another.

Emmanuel Derman’s 1994 note on Convertible Valuation, written with some colleagues at Goldman Sachs Asset Management provides a nice overview of the important valuation components. Not surprisingly, the model presented is an elaboration of work by the late Fisher Black (together with Huang). For the full note of Derman, click on the link below:

gs-valuing_convertibles

But to summarize the note, the important valuation factors are:

Convertible-related Factors

  1. Principal / Redemption Value of the Bond (+); quite obvious, the higher the amount the investor will receive at maturity for the bond component, the more valuable the convertible
  2. Coupon (+); a higher coupon improves the value of the debt cushion, which also translates into a more valuable convertible
  3. Coupon Frequency (+); also logical, if I get 2 times a coupon of $10, I am happier than when I receive that same coupon just one time per year
  4. Conversion Ratio (+); this measures how many stocks I will receive in exchange for giving up my convertible debt instrument. Obviously, the more the better.
  5. Conversion Price (-); the conversion price = Principal/Conversion Ratio. The negative relationship is logical: the lower the conversion price, the quicker the call option component of the convertible will end up being in the money.
  6. Parity / Conversion Value (+); is equal to the conversation ratio multiplied by the current stock price. The higher the stock price, the more valuable the convertible is (see also Market-related factor number 1 below).
  7. First Conversion Date (-); the longer the period during which I can convert, the more valuable the conversion right is. Longer periods imply earlier first conversion dates.
  8. Call Provision for Issuer (-); in quite a few cases, issuers give themselves a call right. It is clear that issuers will use this right once the call option for the investor becomes too valuable. The call for the issuer is therefore a negative value component for the investor.
  9. Call Price of the Call Provision (+); the higher the call price at which the issuer can use his/her call right, the less bad it is for the investor.
  10. Put Provisions for Investor (+); this type of provision is like an extra cushion for the investor. It gives hem the right to demand a certain amount of cash through early redemption (before maturity date) of the convertible bond.

So there are quite a few convertible-related valuation factors that in-and-of-themselves aren’t rocket science in terms of finding the right sign for the relationship between factor and convertible market price.

There are also a couple of market-related factors that should be taken into account:

Market-related Factors

  1. Current Stock Price (+); the higher the current stock price, the higher the value of the option
  2. Volatility of the Stock (+/-); see link with 5 below as well; volatility is one of the most complicating factors in convertible valuation. When looking at the option component, it has a positive relationship with valuation. The upside potential is infinite when looking at stock prices, whereas the minimum price is 0. But this positive ‘vega‘ can be offset by the negative impact on default risk (see 5 below) with in some cases a negative vega as end result.
  3. Dividend Yield (-); since the convertible holder is not holding the underlying stock, but the bond plus call option high dividend payments by the firm are not to his advantage. On the contrary, they will reduce the potential for share price increases. The convertible bond holder would rather see the firm opt for reinvestment of realized profits so as to trigger further growth and increases in share price.
  4. Riskless Rate (-); Convertible bonds are entitling the holder to a potential stream of future cash flows, either directly (coupons plus principal), or indirectly (to the underlying cash flows related to the stock via the option component). Net present value calculation is based on a discount rate, with the riskless rate being the basic component of this rate. The higher the discount rate, the lower the net present value.
  5. Issuer’s Credit Spread (-); convertibles are hybrid instruments in which the default risk of the issuing firm is of importance as well. The debt cushion is just as strong as the credit rating of the underlying firm. The larger the likelihood of the firm going into default, the less valuable the cushion. Default risk levels can be measured through the credit spread, i.e. the additional interest rate premium on top of the risk-free rate that has to be added to the cost of capital/discount rate by the firm. High default risk firms have higher net discount rates, because of the increased credit spread. Therefore this negative linkage.

Factor 5 and its linkage with the earlier mentioned volatility factor (market-related factor number 2) is one of the most complicating aspects of convertible valuation. Markets go through trends as far as volatility is concerned. However, when in periods of fear or panic, this is often directly related to the underlying fundamentals be it at the firm level (high volatility for the firm, with normal volatility for the rest of the market) or at the economy level (high volatility across the board). In both cases the increased default risk – be it real or sensed – translates into a lower valuation of the debt cushion. And that reduces the convertible value that is normally positively related to volatility (via the option component).

2009; THE YEAR OF CONVERTIBLES?

The year 2008 was terrible for convertibles, because the cushion value of the debt component seemed to work less well than investors and their advisors expected. The UBS Global Focus Convertible Bond Index lost 31.7 percent in Euro’s over 2008, a disastrous performance that was only hardly better than the -46% lost by the MSCI World index. There are four reasons for the lousy 2008 performance:

  1. Forced sales by hedge fund managers. Hedge funds were holding 70 percent of the convertible market in 2008. A huge number, that can be asigned mainly to so-called convertible arbitrage hedge fund managers. Excess leverage led to problems for these managers. As a result, they had to delever and sell their assets. This translated into an increased supply of convertibles to the market.
  2. Low number of buyers due to flight into quality/safe-havens. The excess supply could not be sold to buyers, because they were less active or even left the market due to a flight for quality in 2008. Cash was king. The convertible market suffered from the same problems as equity markets did, with liquidity drying up.
  3. The highly pressurized market environment, that hurt all asset classes (credit crisis). The period of the credit crisis was equally stressful for investors in many different asset classes and that was not different in the convertible market. There was fear, and buying and selling behavior was often irrational. This has led to a situation in which – compared to models like the one presented in the Derman/GSAM note presented above – undervaluation went as high as 10-15 percent. Investors simply did not want to step in and this was a unique feature in the normally not that volatile convertible market.
  4. The collapse of Lehman Brothers. Lehman was a big player on the convertible market, both as an investor as well as market maker. Its collapse in October 2008 has hurt the market substantially.

Now, what does that mean for the outlook of Convertible Markets in 2009? We believe that convertible bonds have good potential. First, the average bond yields of convertibles are quite attractive. Yield levels of 9-10 percent are common and that is of course amazing during a period in which yields on regular fixed income instruments have fallen to relatively low levels due to the coordinated actions by Bernanke, Trichet and other central bank presidents. If we add to this the existing undervaluation of convertibles (see above) which normally will be traded away relatively quickly, we do believe that the underlying return related to the debt component of the convertible is actually quite high already. We do not really believe in a quick and sudden increase in risk-free interest rates and even if that would happen due to inflationary pressures, the current credit spreads are full of overreaction by investors in fear-torn 2008. So with a potential reduction in credit spreads, we have some cushion in case interest rates creep up. Added to this, we know that stock prices at the moment are relatively low. With March already showing the first signs of mean-reversion (it was so-far actually one of the best stock market months since 1974), the option component of the convertible has high potential.

Rothschild’s Kris Deblander tells a bit more about how he would construct his convertible portfolio at the moment in this interview:

interviewshconvertiblesfevrier2009anglais574

His Saint-Honore Convertibles Fund won the Lipper Fund Award in his category for the years 2005, 2006, 2007 and 2008. So this guy surely knows what he is talking about. Lodewijk Meijer’s manager selection unit considers this fund one of the best to go for if you want to exploit the potential for a stock price rebound without taking all the risk that comes with stock market investments. Deblander suggests a normal weight of 10 percent convertibles in your portfolio, with probably even an overweight of 5-10 percent right now. We do subscribe to a larger convertible component in the portfolio, albeit that the non-specialist can better outsource the decisions to a specialized fund manager. As we showed above, convertibles look simpler than they actually are. It is a hybrid security with a lot of valuation factors within it and their relative weight is not always clear.

Therefore, if you believe that 2008 was not indicative of the end-of-the-world being there, shares will rebound. Now, the rebound could come quickly or still take some time because we have to go through a period of uncertainty in the economy first. The insurance aspect of the debt component of a convertible is then ideal. We do therefore recommend investors to take a closer look and buy convertibles. US investors are referred to firms like Calamos, Europeans can opt for Deblander’s Saint Honore Convertible Fund.

What we can learn from the Credit Crisis

Posted in Asset Allocation, Emerging Markets with tags , , , , , on March 6, 2009 by evd101

By Erik L. van Dijk

 

On Feb 11, 2009 one the brighest minds in asset allocation, Robert Arnott, gave an interview to US market information provider Morningstar. Arnott, the founder/former CEO of First Quadrant, a firm specializing in asset allocation strategies, made a few things clear:

1) As we already knew from earlier work from French scholar Prof. Bruno Solnik, the only thing that will certainly go up in a period of crisis is global correlation levels. With the exception of maybe gold and frontier markets that are truly secluded – like for instance the IR Iran, the topic of our previous post – everything will one way or another be hurt. Even the Fixed Income markets are not really providing investors with a safe alternative in a period when panic strikes, risk premiums go up and even the safest of the safe end up in big turmoil. The developments in the financial sector were indicative in this respect.

2) When looking at a Diversification 101 lesson that can be learned from our own Harry Markowitz’ s work, or from any MBA text book, the basic idea ‘Stocks for the long run, and Fixed Income and other securities for the periods in between when stocks are not delivering’ is fine. However, we should never forget to define our risk budget in a clear way and above all: stick to it.

3) With respect to 2): the lesson to be learned from Behavioral Finance is that people tend to overestimate their skills in good times, and then – when disappointed – turn to a kind of total disbelief in their own or other’s skills. The outbreak of panic that will follow can lead to disasters, similar to what can be seen in tragic accidents in football or soccer stadiums, when a little fire can cause many deaths in the audience. Not because of the fire itself, but because – in panic – most people want to leave via the same exit. It is the stampede that follows that kills, not the fire. Actually: if all those people running away from the scene would have joined forces, take of their jackets and throw them on the fire it is quite certain that the problem would be solved. The big killer in the crisis is the actions/trades of the ones in panic.

4) So basically, what will happen then, when markets slide into an enormous downfall because of the massive sell-off of shares with all ‘smart’ loss-takers thinking the same smart thing at the same time – as a result of which it is not that smart anymore – is that a situation is created in which smart money can earn a lot. Real winners are made in periods of crisis, not in normal periods. However, when everybody gets crazy and the savvy hold their breath and wait for the bottom level of the market to arise, we should be aware of the fact that the best investors that want to wither the storms by telling their followers that markets are exaggerating will look just as wrong as bad investors do in a normal period. Distinguishing between a top-level investor and an idiot becomes harder in a crisis period.

5) And there will be chances, a lot. Especially further from home, in niche markets that are allegedly risky in the eyes of the global investment community. It is a given that both private and institutional investors tend to have a stronger home bias in crisis times than in other periods. Result: the sell-off was largest in the Emerging and Frontier markets, notwithstanding the fact that economic growth numbers in these markets were not as bad as those in the West. And this is especially strange when also taking into account that these countries have a much smaller percentage of their market cap weights in financials, the sector were it all begun in the 2007/08 (and maybe 09?) market meltdown. I am sure that there will be blue chip investment opportunities in market leaders in Emerging Markets at a price of 3-5 times earnings. PE’s that low do not make sense, and neither does the  fact that the global market cap weight of Emerging Markets is down to 7 percent, a similar level as before the 1997-98 Emerging Market crisis. Things are really different in these countries this time around. China, India, Brazil and Russia (the BRIC nations) are big players now with solid economic home bases, notwithstanding their short term problems because of the crisis. Oil and gas prices are higher than back then and will definitely go up again to levels that might not be as high as what they were last year, but still.

6) But now we have another problem that haunts us. It is risk budgeting related. Institutional investors work with risk budgets, and they should. The ones that apply this technique in a prudent way and directly link it into their asset liability modelling should actually apply the technique in such a way that they do – as an average over the cycle – take a bit more risk when prices are low and less when prices are high. Unfortunately, we often see the opposite. Above average risk taking in times of positive momentum and high stock price levels and below average risk taking when prices are low. Reason being primarily that it is easier to convince the board to allow more risk when you can show nice, upwardly pointing stock price graphs than when you see disastrous graphs with share prices going down, lots of firms going bankrupt et cetera. Psychologically, investment specialists in the pension plan community are normally not fired when buying stocks with nice track records too high (”How could I have known that some kind of change of fortune was on its way? All colleagues were buying this stock too!”), but when something goes wrong with their investment advice when things are going down the drain, the risk of being fired is much higher. This kind of people risk, is a behavioral factor that is still playing an important role in day-to-day institutional money management. Actually, a much bigger role than it should.

7) Now, the problem with market extremes is the following. A simple mathematical exercise will provide you with a clear example:

When prices drop 10 percent (from 100 to 90), we need an 11 percent (10/90) increase to be back at the 100 level. When prices drop 20 percent (from 100 to 80) we need a 25 percent increase (20/80) to be back at the 100 level. When prices drop 50 percent (from 100 to 50) we need a 100 percent increase (50/50) to get back to the 100 level, et cetera.

In other words: the rebound of a market has to be bigger the bigger the crisis is. And the current one was and is big.

8 ) Now, another characteristic of crisis periods is that most risk indicators – like market volatility – go up tremendously. Often to levels 50 or more percent higher than normal. This will imply that market participants that are willing and able to take the plunge and act countercyclically to be among the first to benefit from the crisis will need big risk budgets to benefit. And often, besides being counterintuitive because of the personal risk involved, they don’t have space for that after the calamities that have happened during the crisis.

9) This will in turn imply that two things are really important during the recovery period after a crisis:

9a) Try to find recovery opportunites that add as little additional risk to your portfolio as possible. That is why actually some frontier markets might be of extreme interest (low correlations; compare Iran in our previous post), or asset classes that normally get a relatively low weight.

9b) Buy quality for the longer run. One of the characteristics of a crisis is that people in panic don’t care about anything anymore. For them shares are not securities that entitle them to a share in the firm’s profit, but lottery tickets or casino games that only cost them money. And not just that, they are financial instruments that embarrass them. Sell, sell, sell! But this implies that – when the crisis reaches its end – the battle field will be full with quality firms with now amazingly high dividend yiels (often many times higher than the interest rates available in the market), low PEs and huge potential for growth in the years ahead of us. These strong firms will have themselves nice opportunities to acquire struggling colleagues so as to stimulate revenue growth further, et cetera. In other words: it is the period when the difference between growth and value stocks, and growth and value markets is smaller than ever. Use that fact.

10) Are guys like Arnott and ourselves optimists? Nope, we are just the ‘boring guys’ (Harry Markowitz once used this phrase). Most people – be they institutional or private investors – don’t like what we do in good times (since we don’t take enough risk and are not willing to pay 50-100 times earnings for great momentum stocks in IT, Biotech et cetera) and neither do they like our relative calmness in periods of collapse and crisis. This is not the end of the world, just the end of momentum hunters that went in too late when markets were going up, and now go out too quickly when markets go down. Since we do not know exactly when the shift into upwardly trending markets will be there, it is quite well possible that we will be too early. If that is the case, we will loose a bit before we will win. That is the price of being a smart asset allocator: people will not really like you in the upward phase of a cycle and neither will they in a crisis period. They will only love you over the whole cycle, and even more so over more cycles. This is about sticking to a long-term rational philosophy in which the technique of how to do things is universal and eternal. The individual stocks, asset classes, countries that we like and don’t like do however change, because they will be going through phases. Paul Kennedy’s book The Rise and Fall of the Great Powers gives a good example of how this same line of reasoning applies in history and politics as well.

11) Last but not least: it is not the end of the world. The growing opportunity set is already visible. Be prepared – if and only if you do have space in your risk budget – to try something, but be also prepared to buy things you didn’t buy before. Fundamental indexing is an interesting tool to help you now. Analyzing the difference between stock markets based on market value weights vis-a-vis fundamental weights based on PE, PC, PB, dividend yield, earnings growth and/or revenues might reveal easily where the opportunities are. At the same token, we should concentrate again on Emerging Markets: the fundamental weights of this part of the world are indeed already in the 30-35 percent area with market cap weights now as low as 5-10 percent. That is a huge mismatch. In other words: due to behavioral factors too much money flew back into Western stock markets or savings accounts when things went wrong. Now, with rock-bottom stock price levels and interest rates, it might be worth the effort to look for the true gem stones in the emerging markets. But, never ever forget the risk budget. And the old Markowitz diversifications lessons: when understanding that Gazprom in Russia is now really to cheap, don’t put all available equity money in that stock but add the best opportunity in an country/industry least correlated with Russia and Oil/Gas that also provides you with a quality bet. Optimization and risk management become more important in a period like the one immediately after the crisis, because a good approach in that area will help you recover quicker with relatively less risk which will improve the return/risk profile of the portfolio substantially. And that is really necesssary after the disaster of the crisis period that has just ended.

For the full 4-5 minute interview of Arnott with Morningstar CLICK HERE.