Convertibles are Back in Style

As summer rolls in, convertible cars will hit the road for the season.  In this post however, we take note of convertible bond issuance and the investors.

The global issuance of convertible bonds has moderately increased in the last three years, averaging volumes of $57 billion and 250 issues per year (Figure 1).  As of May 2016 for this year, $22 billion and 71 issues have been placed.  A tightening stance by the Federal Reserve could be spurring the issuance of corporate bonds ahead of higher interest rates.

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In the past 3 years, the top sectors of Financials, Technology, and Communications have averaged 53% of issuance each year.  This year, the Energy sector became the 3rd highest with 15% of the new issues (Figure 2).

The growing issuance by Energy is notable given the widening of high-yield credit spreads in the sector’s CDS for the past year (Figure 3).

Investors in convertible bonds include investment advisors, hedge funds, and insurance companies.  According to BarclayHedge’s hedge fund database, Convertible Arbitrage Hedge Fund assets under management are at $22.4 billion, as of 1Q 2016 (Figure 4).

A convertible bond is a hybrid security with a bond and its underlying stock.  The bond portion receives regular coupon payments and the repayment of principal at maturity; while the upside call option conversion to the underlying stock provides the equity exposure.  As the equity price increases, the market value of the convertible bond changes from a “bond-like” to “equity-like” value, with a hybrid behavior in between (Figure 5).

The equity call option provides a sophisticated way of trading volatility on a delta neutral basis with the bond and the underlying equity.  This convertible bond arbitrage strategy is favorable when the equity price enters the hybrid zone.  Potential gains are possible for a long bond position from the underpricing of the call option’s implied volatility, and the rebalancing of the equity hedge – a technique known as dynamic hedging.

The first derivative delta measures the change in price of the option, given a change of the equity price.  The change of the delta is then measured by the second derivative gamma.  A long options position has positive gamma, which could lead to a profitable position with dynamic hedging.

There is a subset of convertible bonds in the United States that are traded electronically on equity exchanges.  The Bloomberg function PSCH<GO> can search for these convertible securities (Figure 6).

Investment advisors (79%) and hedge fund managers (16%) are top holders of these convertible bonds and preferreds (Figure 7).

For a long volatility trader, a high gamma convertible bond is attractive.  Ranking these bonds by gamma, 83% of these bonds have a positive gamma (Figure 8).

To execute a convertible bond with the equity on Bloomberg Tradebook’s PAIR Multi-Asset platform, a trader will use the Equity Link ticket: “Buy the bond at $57.10 versus selling stock at $72.75 on a 0.7712 hedge, delta neutral.” (Figure 9)

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