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

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.

Fund Manager Selection Part 2; The Institutional Investor

By Erik L. van Dijk

During the last few days we discussed topics related to the behavior of Private Investors. We analyzed how they choose their fund managers, individual stocks, how their decision processes work and even addressed differences in style between the genders. Now, for analyzing the behavior of Institutional Investors we first had to study the Private Investor. In the end, decision processes of investing institutions are always processes in which individuals act together. In other words:

Whatever we derive for private investors, will – one way or another – have an impact on decision taking in institutions, because in the end every professional working in an institution is a private person as well.

We can add a bit more detail. Professional investors are often mainly involved with fulfilling their tasks on portfolios of third-party money. This implies two things:

1. The existence of agency-related problems. Unlike the situation that we discussed a few days earlier when analyzing the investment behavior within investment clubs, we are dealing here with group processes similar to the ones studied by Jensen and Meckling. The bottomline was and is that agents – when not controlled in a sufficient manner – can and will incorporate their own goal variables in the decsision process. This could lead to ‘style differences’ (see also below) with respect to the investments done, or even to outright acting against the interests of the principal. See our entry on the behavior of investment clubs for more details.
2. Group psychology plays an important role on the decisions taken. Group size and composition are therefore  important variables.

From these 2 points we can therefore derive 4 important elements to study:

• Investment style differences (Agency element nr 1)
• Agent-related goals (Agency element nr 2)
• Group size
• Group composition

But we have to add two others:

A) Management and control structure within the institution

B) Type of institution.

With respect to A) and B), investment decisions are just one part of the overall activity set of institutional investors and its relative role is not the same in banks, insurance firms, investment banks or pension funds. Management boards in banks and insurance firms are often filled with non-investment-specialists who – as a controlling body – work together with ”respected colleagues” from other firms filling the ranks of the board of directors. The higher ranks in investment banks are often filled with the most successful and toughest guys with investment knowledge. They used to do what the specialists are doing now, but moved to management plus the bigger deals. In a pension plan the governance structure often implies a controlling body with a lot of non-specialists, be they representatives of the sponsor, employees or government. A very complex control structure that is far more sensitive to public opinion and daily news gathering and information dissemination than the others. And to make things even more complicated, there is also the difference between so-called ‘Defined Benefit’ (DB) schemes and ”Defined Contribution” (DC) plans.

Defined Benefit (DB) versus Defined Contribution (DC); a sub-categorization within the institutional investor category Pension Plans

In a Defined Benefit structure pools are created in which one investment style / portfolio applies to the whole group of members, be they young or old, men or women, high-income or low-income. Obviously, this middle-of-the-road investment style might be sub-optimal for many, but the social aspect of it (”we all stick together”) has certain benefits as well. As we saw in our earlier contributions, investment success is not something easy and since in the end a pension plan is about making sure that you have enough money when reaching old age, this kind of pooled structure ensures that no one can be the victim of his/her individual mistakes caused by non-professional bad investment decisions.

For more information about Defined Benefit (DB) plans CLICK HERE.

It is probably no surprise that the ideas behind DB were quite popular in nations with a culture of social cohesion. European nations like the UK, the Netherlands and Scandinavia are good examples of markets with large DB plans. Actually, a relatively small country like the Netherlands with just 16 million inhabitants is the fourth largest pension market in the world. And this is directly related to the creation of big DB plans that has been started in the 1950-60s.

The social aspect of DB plans is strong and attractive, and it is therefore not surprising that Emerging Markets that have achieved a certain wealth status are contemplating the introduction of similar structures. E.g. the IR Iran is working on a pension structure similar to what has been created by the Dutch in the 1950s or the Norwegians during the last 10-20 years. The existence of gas and/or oil reserves in both these countries and in Iran is not coincidental of course.

Now, the big problem with DB is exactly that: DB. Defined benefit….you know upfront what the end-result is supposed to be. However, there are uncertainties in the world. The end result is a function of: a) investment results; b) demographic factors and c) economic factors, with the premium inflow being covered in the economic category. With demographic factors working against pension plans by definition in the West (people get older and a smaller relative number of people is working), obviously pressure on the structure will be huge whenever economic and or investment factors work against it. And that is what is going on at the moment. Social cohesion is under huge pressure in DB countries simply because of that. In all these nations, younger generations are pressing for either full-scale DC alternatives or DC components as an add-on next to a minimum-level DB structure.

In a pure Defined Contribution (DC) plan, the pension fund is nothing more but a provider of various investment opportunities, be they funds or pools, in which members can invest according to their own belief (what mix to choose?) with or without guidance by the pension plan. The minimum achieved is cost advantages, since the DC plan uses its scale to get the funds chosen against some kind of fee rate not available to members individually. But hopefully, the DC plan did also use its knowledge about fund manager selection when pre-selecting the funds in its choice portfolio for the members.

The DC structure is most popular in countries in which some kind of individualism was and is strongly developed. The US market is of course the most important one. The main certainty is that you save for your own old age. But, with the contribution being sure, the uncertainties now are the economic and investment ones. Whenever you invested the wrong way, your end result will be disappointing. Maybe even insufficient to avoid poverty!

For more information on DC plans CLICK HERE.

Investment and selection style by Type of Institutional Investor‘

In the remainder of this blog entry we will now analyze the various components mentioned above for the three different groups of institutional investors that we can distinguish.

I) The aggressive guys; Investment Banks and Hedge Funds

Investment bankers and hedge funds that also use substantial parts of their own money are the real risk takers. You can classify their styles based on what we told you in our blog entry on differences between men and women (see here) as typical ”macho”. They are in there for the quick buck, fast deal, and aren’t afraid to take big risks. High, often excessively so, leverage is a typical characteristic of the style of these guys. When successful they think that they are the best and can get away with everything. Yes, to a certain extent you could say that they are the guys that caused maybe not the whole credit crisis, but definitely the momentum and exuberrance that in the end made the system explode. As long as they do it with their own money, or with that of investors that do understand some investment basics, that is all fine. However, when they label themselves ‘investment magicians” and attract money by others while at the same time not being controlled carefully enough, because the regulatory authorities do not understand the difference between a ”miracle investor” or ”magician” or ”someone just having plain luck” this can be very harmful. And that is what happened. Even smart people seemed to have forgotten how long it takes before guys with casino strategies are not part of the alleged magician group anymore.

Example: Assume that there are 100 investment bankers/hedge funds out there that do only one stupid thing. They flip a coin and when it says heads they go long with all their money in dangerous stock investments. When it is tails they go long with all their money in some kind of fixed income, gold or other defensive investment. After one year there are still 50 coin flippers labeled good investors. After 2 years 25, After 3 years 12, after 4 years 6, after 5 years 3, after 6 years 1.5 /2 and after 7 years there is one of our 100 guys who can say that he outperformed the whole 7-year business cycle. And believe me, he will attract a lot of money when capable of doing business with people that don’t ask him too many nasty questions about his investment ”strategy”. And yep….you do immediately see now why Madoff could happen!! Admiration without checking results.

With respect to investment style and manager selection, these guys are not afraid of anything. They will actually love the most risky deals. They like frontier markets more than defensive solid investments in fixed income in established nations. They prefer distressed firms over mature solid ones. Et cetera. It is good to go with them up to a certain extent, because they often use their own money. But, to the extent that they might be sensitive to overconfidence (the macho thing), always make sure that they hold the best-possible, diversified portfolios. In our case, we would require them to be Markowitz-van Dijk compliant, i.e. true champions in diversification. To the extent that they have invested in talented small managers, they are good for the system in that they are not afraid to give money to these talents. But only to the extent that the talents are really talents of course, and – as shown by the previous example – that is difficult enough when you don’t know how to ask the right questions and perform the right performance analyses.

II) Banks and Insurance Firms; Non-specialists with Investments not being the main activity

They earn their main money with other products, be they banking/savings related or insurance products. But because of developments in the financial industry, all of these products got a larger linkage with the investment world. In the end you will have to invest money – be it your own, or that of your clients – somewhere. After the collapse of the pure savings banks back in the 1980s and the transition from pure insurers into bankassurance in the 1990s we did indeed see some indications of diversification understanding. So, being non-specialist, the decision takers here – who have probably the relatively largest amounts to invest due to their scalable product offering to the economy at large – do diversify. But it is definitely not the top-level, diversification and risk management activity that can be labeled Markowitz-van Dijk compliant. It is amateur diversification and risk management as a result of which disasters like the investment in securitized mortgage portfolios in the US could happen. They really believed that having a portfolio of large amounts of mortgages from all over the US would be diversification. That there are more dimensions to this thing than just plain geography and that correaltions between Seattle and Florida are pretty high in a time of crisis and economic malfunctioning was totally forgotten. They have never seen the work of French top professor and diversification specialist Bruno Solnik on the relationship between crises and correlations. Or they saw it and didn’t believe it was important, because they sticked with the big names. Non-specialsts always overesimate themselves not to the extend of taking too much risk knowingly, but to the extend of thinking they know what to do and how to do it. Result: huge investments in investment vehicles and structred products created by well-known, allegedly successful institutions. Be they large asset managers, investment banks or hedge funds.

Or: they translate their alleged knowledge into the belief that they should have their own asset management branches to develop these products internally! And to some extent you could say that this ”strategy” might also partly explain why – on average – good boutiques outperform large houses. Too often do large houses start things when not being a specialist. The ”macho” overconfidence of a bad boutique is replaced by ”breadth” overconfidence!

So in a way, using money from external clients and with a mind set that focuses first and foremost on risk reduction, these institutions should have invested like women do. Study information thoroughly, dig into the details, take not too much risk, diversify and avoid overconfidence. Unfortuately, women decision takers are a very small percentage of the boards of these instituions. Therefore, we cannot be too surprised that the big failures happened in this group of institutional investors during the 2007-now credit crisis. Out of synch with their own style and goals, and not capable of distinguishing between sharks and frauds on the one hand and true specialists on the other. It is not a surprise that it is especially true that investment affiliates of these entities invested a lot in Madoff!

III) Pension plans

As a group, the true specialist pension plans that basically act as a kind of end investor (definitely so in the DB case, and to some extent in the DC case) or his direct advisor through pre-screening (DC plans) are normally when looking at the return-risk profile the best institutional investors. Logically so, because they do have all the information available, they do have armies of specialists working for them and they do work structurally with consultants.

So when we concluded that on average institutional investors have better returns than private investors, see our earlier entries, we should at the same time add that the difference is shockingly small. When investments are at the same time art and science, the specialists should outperform the non-specialists by a wider margin. That this is not the case, is the result of overconfidence on the one hand, and lack of honest, sincere performance measurement and analysis on the other. The difference between true investment professionals and their performance on the one hand, and the amateurs on the other, should not be as small as to make funny stories about King Kong throwing darts and beating the specialst possible. Definitely not when analyzing diversified portfolios created by true specialists.

Now, how come things can go so terribly wrong, also when we look at the pension plan investors? To one extent this is directly related to the agency argument. Pension plan investors are not using their own funds (like the co-investing investment bankers and hedge fund managers) and that could probably lead to some agency aspects playing a bigger role than they should. It is good that new governance structures and control- and regulatory mechanisms are being created that will further mitigate this problem. But it is still there.

On the one hand this leads a lot of pension plans to investment styles similar to that of banks: overweighting of established ”big names” with middle-of-the-road products (the ”you never get fired for hiring IBM” argument), whereas actually they do know enough about investing to go for a best-of-breed approach with more bold products on an individual basis linked together into a well-diversified overall portfolio.

And also: although they are the true specialists, their boards do also contain large components of non-specialists with quite an impact. Be they government-related or labor-union related. Amidst fear and panic, the relative importance of these groups within the decision structure grows bigger. As a result of this, there might be a tendency to sell the most risky investments at exactly the wrong moment. And that was happening in 2008! Instead of buying low and using the crisis as a once-in-a-life-time opportunity, these investors were actually in Q3 and Q4 of 2008 selling in many nations where we have good information about the buying and selling of DB investors. And obviously, the same pattern was even more prominent in DC plans, because there the end investors (individual members) were panicking themselves.

The whole system of calculation of how DB pension plans in this structure are doing, through the use of so-called coverage ratios makes things even more compicated. The average time to maturity of liabilities of pension plans (measured by the duration) is higher than that of its assets. That leads to the weird paradox that – when interest rates decline to bottom levels, like right now – the net present value of the liabilities goes up to such an extent that the coverage ratio will probably decline to levels not acceptable for regulators or boards.

That leads to tension and increased relative importance of the non-specialists within the board exactly at the time when the true specialists should take the lead. Result: what is sold is NOT the parts of the fixed income portfolio that made above-average returns during the period just finished (e.g. investment grade bonds that went up in value due to interest rates moving to zero), but actually stock components of the portfolio are being sold in a period of total sell-off of stocks in the first place. And even worse: within the stock component of the portfolio stocks from markets that are fundamentally strong in the long run (emerging markets) are sold first and foremost before selling-off the stocks of firms in your own country. Reason: ”we cannot – often for political reasons – start with a sell-off of our own stocks, because this might hurt local firms and therefore also employement and the economy.

Conclusion

Institutional investors, and that holds especially for those that are willing to co-invest with their own money or the ones that are true professionals, should generate above-average returns at a far better scale than they actually do. King Kong and individual investors / investment clubs shouldn’t be competition when looking at their results. It is a disgrace that they often seem almost as good. Amateur base ball clubs from let’s say a high school in Anchorage, Alaska are just a ridicule when trying to compete with the Florida Marlins and that is how it should be in investments as well.

Credit Crisis: Post-scriptum

What does this mean for the credit crisis? It means that it is not so clear that institutional investors as a group will get us out of this mess soon. True, some of the bold investment bankers that survive the current liquidity squeeze and de-leveraging will be among the first to try to use the (almost)zero interest rate situation to buy into deal portfolios with above average prospects. But are they big enough to move the market? We at Lodewijk Meijer believe they are not. Only when the so-called Sovereign Wealth Funds will join them, will the system switch back into optimistic gear. In a next entry we will therefore have to pay separate attention to this new phenomenon that became important during the last 10 years.