Once bitten, twice shy

By Shawn Mato

Despite the success enjoyed by convertibles-based strategies in recent years, too many investors are still rattled by the losses incurred way back in 2008. Nowhere is this more apparent than in the hedge fund market where convertible strategies remain notably unpopular even though they continue to outperform.

In the year to the end of February, convertible bonds delivered 14.5 per cent[1] – well over three times the return from corporate bonds, and with less volatility. Over one, three, five and ten years, convertibles have also delivered a good portion of the returns generated by equities but for around half the risk. This has allowed convertible hedge fund strategies to comprehensively outperform all others. In the five years to the end of January, Credit Suisse’s three convertible arbitrage sub-indices soundly beat the returns from all of the 31 other hedge fund strategies in the universe. Indeed, the Blue Chip Convertibles Arbitrage Hedge Fund Index delivered over 50 per cent more than the best performing non-convertible strategy[2].

Even so, memories of the losses incurred during the violent deleveraging of 2008 mean that such strategies rank dead last in popularity among hedge fund investors. However, the declining prominence of hedge funds has had a hugely positive effect for the managers of mutual funds thanks to the increased level of alpha that is now available to them.

Trading places

Ironically, mutual fund managers have the financial crisis to thank for this. Prior to the crisis, hedge fund investors accounted for around 75 per cent of total investment[3]. However, when valuations were caught in the violent sell-off of 2008, a great many hedge funds were faced with ruinous margin calls and subsequent restrictions on leverage. Until then, hedge funds would typically lever their assets by a multiple of four or more[4]. Today, few are thought to employ leverage of more than two times which explains why total leverage in the market has fallen from an estimated 2.5x in 2008 to closer to 1.1x today.

Consequently, today’s market bears little resemblance to that of only six years ago with long-only managers now the market’s dominant faction. One consequence of this is far greater inefficiencies in market pricing and this has created a rich source of alpha for those managers with the necessary skills.

A class apart

As a rule of thumb, companies that issue convertibles are often light on hard assets, but strong cash generators with low gearing. And, we estimate, that for up to 70 per cent of issuers, convertibles are the only form of listed debt. Such companies are attracted to convertibles as they offer greater flexibility than conventional bonds, a lower accounting charge and lower coupons.

Although equities are expected to make progress in the year ahead, it’s unlikely to be a smooth ride, which means that convertibles offer an attractive way to reduce overall portfolio volatility while adding valuable income and low-cost downside protection. Meanwhile, the shake-out of the investor base has introduced a new level of pricing inefficiency with convertible valuations now ranging far more widely than they did prior to the financial crisis.

As most convertibles are issued with durations of between five and seven years, they’re likely to become a popular choice for fixed-income investors as bond yields start to rise. Convertibles issuance has already rebounded to its highest level since 2010 and, once official interest rates start to rise, issuance should pick up again as more companies seek cheaper financing. Coupled with the prospect of inefficient option valuations, misunderstood credit and an attractive calendar of new issuance, there should be no shortage of relatively low-risk alpha opportunities on offer to the market’s more experienced mutual fund managers.

Shawn Mato is a global convertibles senior fund manager for Aviva Investors