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Convertibles
offer the best of both worlds
Historical evidence shows that convertible bonds as an asset
class offers upside participation in equities and the downside
protection of the bond floor, regardless of changes in interest
rates. Since 1973, the U.S. convertibles asset class has delivered
70% upside participation with the S&P 500 in rising markets
and only 52% downside participation when equities were declining.
The same
statistic for the European markets from 1998 demonstrates
52% upside and 35% downside participation.
How do convertibles react to an interest
rate increase?
Contrary to received wisdom, convertibles
are not significantly sensitive to interest rates and can
be a valuable tool for investors looking to hedge against
interest rate risk. Historical evidence shows that convertibles
are actually far more closely correlated to equity markets,
and display very low levels of correlation to changes in interest
rates.
Furthermore, by holding convertibles, an investor
with a fixed income portfolio will enhance the risk/return
profile of his portfolio and diversify away some interest
rate risk. The reason for this is the hybrid structure of
convertibles; they have both equity and a bond component,
and as a result behave like neither asset when interest rates
move.
This is because these two components normally
act in opposition to each other in response to changes in
interest rates. Because of this dual composition convertibles
provide investors with a natural hedge against interest rate
risk, as the impact of a rate change is balanced off between
the equity component and the bond component of the convertible.
Convertibles: an asset class for all
market conditions
Since 1973, convertibles have shared a correlation
of just 0.26 and 0.21 with long- and medium-term treasury
bonds. This remarkably low level of correlation is in stark
contrast to the 0.83 and 0.84 correlation between convertibles
and large and small cap stocks.2 This indicates that equity
markets are far more important than interest rates in determining
the performance of convertibles.
It also suggests that convertibles can provide
a natural hedge against rising interest rates. The option
of converting into equity at a potentially higher market price
in the future gives a convertible additional value above and
beyond the equity and bond components of the convertible at
issuance. This optionality gives rise to a phenomenon called
convexity, and explains why convertibles participate more
in upwards moves than in downwards moves in equity markets.
How convertibles
can act as a hedge against rising interest rates is explained
by the reaction of convertibles to rising equity prices. Such
rises tend to increase the value of the equity component of
convertibles, offsetting or usually more than offsetting,
the lower value of their fixed income component. Bond-like
convertibles, with lower equity sensitivity, also provide
a hedge against interest rates, as they are closer to maturity
than traditional bonds. This reduces the asset’s sensitivity
to interest rate speculation, thereby reducing the impact
of interest rate risk.
Finally,
convertible bonds offer protection to an equity portfolio
because of their downside bond floor, which effectively limits
possible losses in the event of a sharp fall in equity prices.
Internaxx
is a multi-market and multi-currency securities dealing service,
launched by the Bank of TDW & BGL S.A. a joint venture
between TD Waterhouse Group Inc. and Banque Générale
du Luxembourg S.A.
Internaxx
offers real-time access to thirteen international stock exchanges
in North America, the UK and Continental Europe, and to offshore
mutual funds. The Bank of TDW & BGL's place of business
is Luxembourg, and the Bank is regulated by the 'Commission
de Surveillance du Secteur Financier', Luxembourg.
For
further information, international investment research and
trading in thirteen markets call:
00800 2003 2003 (freephone) or visit the website at www.internaxx.lu
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