Equities For Cowards, Bonds For Heroes

GAM launches UCITS III convertible bond strategy

Originally published in the March 2011 issue

The post-crisis uncertainty of 2009 and 2010 produced vast flows of money into bond funds. Much of that cash is expected to move into equities in 2011 as fixed income investors begin to fret about rising yields. But with risks to the global growth outlook refusing to disperse, Ben Helm and Alex McKnight of GAM believe convertible bonds’ equity-style upside and bond-style capital protection should make them the asset class of choice for both bond and stock investors.

Helm and McKnight have 34 years of convertible bond management between them, but first began co-managing convertibles together at Augustus Asset Managers Ltd in 2007. There, the pair ran a convertible bond portfolio both as an onshore sub-strategy of Europe’s first UCITS-compliant absolute return bond fund and as a standalone offshore proposition.

GAM’s acquisition of Augustus had several repercussions for the convertibles strategy. It gave the team the added benefits of GAM’s considerable infrastructure and global distribution reach. It also helped grow GAM’s assets within specialist fixed income and currency to roughly US$17.2 billion (as of June 2010). In addition, GAM’s experience of European fund structures enabled the onshore strategy to launch as a UCITS III fund with daily dealing. So while the new product does not use the gearing available in the offshore version, it does allow a wide range of investors to benefit from convertible strategies.

What originally attracted both managers to convertibles was the blend of upside potential and downside protection that comes from the make-up of the convertible bond itself. A convertible is essentially a normal corporate bond that pays coupons and is redeemable at maturity, but also carries an embedded option to buy stock in its issuer at a given price. It is this that gives the asset class its unique asymmetric return profile: if the underlying stock performs well, a convertible investor can participate in those gains. If it does not, the convertible still performs as a bond, providing yield and capital protection. “A convertibles strategy automatically scales you into equities as they rise and back out of them as they fall – the ideal scenario for most equity investors,” says Helm. “Equities for cowards and bonds for heroes” is McKnight’s description. “Why take the linear risk of pure equities when in convertibles I can isolate precisely the risk exposure I want, actively manage it, and all the while be protected on the downside?”

That advantageous risk/return profile is behind the appeal of a convertible strategy in its simplest form. For investors with fixed income allocations who are looking for exposure to growth trends which could erode the value of their bond holdings (through higher interest rates), convertibles are an equity-like bond. For equity investors who are concerned that stock market volatility, political uncertainty and stuttering economic growth are taking their portfolio risk above acceptable levels, convertibles are also the ideal crossover asset.

Convertibles advocates also point not only to the low correlation the asset class has to ordinary bonds and equities, but to the strong historical returns it has made relative even to equities. Convertibles, as measured by the UBS Convertible Global Bond index, have returned around 78% over the last ten years (to 31st January 2011), compared to just 35% for the MSCI World Equity Index. Helm and McKnight’s offshore strategy has also performed strongly, generating annual compound returns of 7.0% net of fees since inception in July 2005 [1]. Helm and McKnight can also attest to a divergence in performance at inflection points. For instance, when credit markets rebounded from a sell-off in late 2002, the recovery in convertibles was simultaneous: the corresponding upwards move in equities did not come until March 2003. A near-identical early convertibles resurgence was seen in late 2008 and early 2009 following the 2008 financial crisis. It is a pattern that repeats itself, says McKnight. “When credit is doing well, convertibles do well and when equities are doing well, convertibles do well.”

Like other securities, convertibles come in a wide variety of categories, based on their issuer, underlying equity, the terms (and price) of the paper itself, and the interrelationship between them. With a global convertibles market that today accounts for some $600 billion across Asia, the US and Europe, the team has a very large universe to choose from. What is more, with rising interest rates making issuing convertibles more attractive to corporates thanks to their low yields relative to corporate debt, that universe is likely to continue to grow. “On a fairly basic level convertible bond issuance makes sense right now,” says Helm. “European and US banks are restricted in their lending at the moment due to capital constraints, but given constant demand for corporate debt, companies are raising capital through bonds. Over the last few years money has been more or less for free. Last year high yield companies rated in the US could issue seven-year paper with mid single-digit coupons. With yields rising, those days could very soon be over.” The trend for higher convertible issuance is already being felt in Asia, where it more than doubled in 2010, accounting for roughly a third of new convertibles globally. To help them select the best names from the universe, Helm and McKnight use a top-down macro and sector filter based on key economic characteristics, in combination with extensive bottom-up research. Companies are analysed in collaboration with the 14 other fixed income specialists in the wider team both through one-to-one company meetings, and an exhaustive focus on fundamentals. The views this process produces are re-evaluated on a day-to-day basis.

At present, the 60-odd holdings in the GAM onshore convertible strategy are spread across global markets with the largest exposures in Europe and Asia. The strategy only has minor holdings in the US market, amounting to less than 6% of the portfolio. This is due to the structure of issuance in the US rather than any fundamental reason. The strategy currently has a positive bias towards materials, in particular oil and copper. This copper exposure is through a diversified Canadian name with substantial holdings around the world. Such is the geographic diversity of the global convertibles market that one of the strategy’s largest holdings is a Malaysian government holding entity linked to a local toll road operator.

While long only convertible strategies exist, in which investors simply look for equity upside while enjoying the defensive income characteristics of the convertible instruments, the GAM UCITS product is not one of them. Rather, Helm and McKnight run their portfolio on an absolute return basis. They go about this by adapting their portfolio to express specific views, both through investment strategy, and by using derivatives whose use is permitted under UCITS III, either selectively or as part of a systematic overlay hedge.

Convertible bonds are particularly well-suited to this kind of strategy. Their combination of credit and equity exposure, interest rate risk and in-built optionality, in combination with the hedging strategies that are permitted under UCITS III, makes them hugely customisable. “You can pick and choose the exposure you do and don’t like,” says McKnight. “What you are left with is a product for all seasons. If you are worried about credit markets, fine, take that risk out. If you are worried about equities, take some of that risk out. Even better, because of the optionality of the convertible, you can set yourself up to generate returns for most of the downside.”

The team’s approach within the GAM onshore convertible bond strategy can be broken down into three key trading strategies: ‘mispriced'; ‘event driven’ and ‘directional’, which make up the bulk of the strategy’s positions. Each can be used to try to maximise returns in specific market conditions.

Mispriced trades take advantage of convertibles whose prices have been driven down to artificially low levels, often by liquidity factors. For instance, forced selling in the market might see a well-structured company with a strong cash balance sold down in line with its less robust peers in a sell-off. This happened most recently in May 2010, when some convertible bonds were trading well below their fair value relative to their credit or equity. Or in McKnight’s words, “If something is free, it’s the wrong price.”

Event-driven trades are very specific, and look to exploit ‘make-whole’ covenants in convertible bond prospectuses, which guarantee the convertible bond-holder will be paid the full value of the embedded equity option in the event of a takeover. At certain points in the life of a convertible instrument, this might represent a premium to the value of the bond, and at other times, that premium may be priced in. The GAM team’s proprietary models constantly monitor precisely where bond prices are relative to their payout value, and the team is able to select opportunities as they arise. From the other side, the team can also look at expected take-out prices, and value bonds accordingly. The wider fixed income team’s regular meetings with companies also help here – these often focus on pre-deal situations, feedingdirectly into event driven trade strategies.

In this kind of trade, the team rarely holds a bond all the way to takeover, preferring instead to exploit the move in price that tends to happen in the initial stages of a potential takeover. Reducing exposure prior to a concrete takeover result locks in gains for the portfolio while avoiding the risks that inevitably surround the takeover itself.

A trade within the team’s third strategy, directional, will in essence be based on a specific view on a credit, its underlying equity, or both. In general, the team will not initiate a position unless they believe in the quality of either or both of these underlying components. A view can be expressed by shorting either, or by owning both and hedging out a portion of the wider risk. For instance, if a particular convertible bond has a strong correlation with an underlying stock in which the team sees downside, but itself represents an attractive credit, they can over-hedge on the equity side and generate returns both on the improving credit position and the falling equity.

In the current environment, the bulk of the team’s trades are long positions in names that are trading as balanced convertibles, i.e., convertible bonds that take full advantage of the convexity of their return. Downside in this kind of position is limited to a few percentage points, but by selecting names that are either cheaply valued or have significant upside potential, the strategy can benefit from a subsequent rally in the underlying stock. In today’s volatile environment, out of a total of 50 such names, one or two might be expected to break higher in a given month based on, say, newsflow or corporate results. Should a stock rally significantly through its target, the team may short the stock through a total return swap, in expectation that it will pull back to fair value.

Here, the convertibles structure gives Helm and McKnight a timing advantage. A convertibles investor can sit on a bond that pays him coupons, all the while being paid to wait for the positive quarterly result that will start a stock rally in which he will participate from the start.

The use of derivatives to manage risk around a particular view is one of the things that distinguishes the absolute return-oriented GAM onshore convertible strategy from a simpler long only approach. In addition to trade-specific hedges, the GAM team uses a systematic overlay based on a macro view at one end and a localised sector view at the other, in order to provide tail-risk protection. “As we all know, markets like to march steadily up the hill but when they fall, they tend to fall sharply,” says Helm. “As a result, we always need some level of protection in the portfolio.” The ability to do this is especially useful in times of high uncertainty. As it stands, Helm and McKnight continue to expect growth, but also see risk in the economy and markets, and the strategy is positioned accordingly.

No matter how efficient the overlay, there are always additional risks in the market, and the GAM team manages overall portfolio risk in a number of ways. There is a value at risk limit in the portfolio and the managers also keep constant tabs on the absolute loss potential of the portfolio. “We always know what our risk numbers are,” explains Helm. “That is how we try to retain value for investors. We are always looking for upside, but in particularly difficult periods we would look to be flat.”

The overlay structure means that the team’s views can alter – and those changes can be expressed – much faster than in a simple long only portfolio. Thus, while the portfolio turns over between once to one and a half times a year, this is not representative of the work Helm and McKnight put into actively managing their risk book to match the strategy’s positioning with their views, and in the process smooth or enhance returns. “Markets do not go up in a straight line, and our view will alter over time,” says McKnight. “We aim to take advantage of every move that happens. We look to provide investors with absolute returns, and to keep the duck swimming smoothly across the pond there is an awful lot of work going on under the water.”

Helm and McKnight’s experience and track record suggest that even in difficult times, their approach may deliver smooth, uncorrelated, risk-adjusted returns. Indeed, with the outlook for 2011 currently anything but clear, perhaps the only certainty is the convertible strategy’s appeal.

[1] Past performance is not indicative of future performance.

Ben Helm is an Investment Manager, co-managing convertible bond funds. Ben joined GAM following its acquisition in May 2009 of the fixed income and foreign exchange specialist, Augustus. Prior to joining Augustus, Ben worked in a number of roles primarily in convertible bonds sales and trading at ING Barings from 1991 and HSBC from 2001. He started his career at Morgan Stanley International in 1986. Ben holds a BSc from the University of Edinburgh.

Alex McKnight is an Investment Manager, co-managing convertible bond funds. Alex joined GAM following its acquisition of the fixed income and foreign exchange specialist, Augustus, in May 2009. Alex joined Augustus in 2007 from Allied Irish Bank (AIB), where he was a senior trader for European convertible bonds within the fixed income group. Prior to this he was a credit analyst at AIB and began his career there as a foreign exchange trader in 1996. Alex holds a BCom from University College Dublin and is a CFA charterholder.

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