Manager Writes: Julius Baer Investments

The benefits of diversification within a convertible portfolio

Peter Henry Hale

Since the significant withdrawal of liquidity and subsequent sell-off in the convertible market in 2004 and early 2005 there has been wide ranging debate as to the outlook for the convertible product. Are pure convertible funds something of the past? Is the strategy only viable in a rising volatility environment ? Are multi-strategy funds best placed to operate in the sector? At Julius Baer Investments Limited we strongly disagree with these latter thoughts, and believe that a balanced convertible portfolio (both by trade type and geography) is one that can perform in almost all market environments.

To date the convertible bond product has made a strong recovery through 2006 and is one of the better performing hedge fund strategies of the year:

The convertible product offers a balanced way to take both macro and micro equity views, volatility and credit views and gain exposure to the M&A cycle. If one uses convertibles as a broad based way to play these markets, rather than as a purely directional or volatility-based strategy, there is a strong case for convertibles, save for a high implied volatility market. By exercising from an economic, equity, credit and volatility perspective investors will potentially benefit from the full characteristics of the product, rather than purely one strategy. The chart below shows that there are a variety of available strategies in the convertible bond universe including convertible bond arbitrage, directional convertible bonds, low premium carry trades and corporate event (M&A) trades.

In a low volatility environment there is a compelling risk-return argument for investing in convertibles as a smart way to take equity-like exposure. An investor can participate in the equity upside whilst locking in the downside by either hedging out the bond portion of the convertible through buying credit protection, applying asset swaps, by purchasing exchangeable or synthetic bonds of high credit quality. Alternatively, one can run risk, and potentially accumulate marginal return, by not hedging out the credit portion of the structure. In the event of an equity market sell-off the convertible significantly outperforms the underlying equity. In a rising equity market (i.e. 2003 – 2006) whilst the implied volatility declined, strong returns could have been made not only through an allocation to a portfolio of bonds with high convexity and high delta exposure but also through significant credit tightening.

In a high implied volatility market a credit-hedged portfolio with significant vega and gamma exposure will be preferred. This is the environment that caused so many difficulties in 2004 – 2005. The volatility space was increasingly overcrowded as it had become the main focus for convertible investors, significantly reducing arbitrage opportunities at a time when index and single stock volatility was steadily decreasing.

As corporates rebuilt their balance sheets post the difficulties of 2001 – 2002, credit spreads generally tightened and, with a lack of corporate activity, volatility plunged. Increasing amounts of money were chasing a strategy with decreasing value. This created the ‘perfect storm’.

The convertible bond strategy has started to look more appealing again as implied volatility started to pick up from mid 2005 (see chart below).

Convertibles still offer a compelling way to play the corporate event cycle. Clauses on many converts offer protection for convertible holders and offer significant out-performance vis-à-vis equity holders. The current mass of corporate activity leads to a possible triggering of these clauses, a pick-up in single stock volatility and, in the event of it being a LBO transaction, a significant widening in the relevant credit default swap contracts. Convertible holders are potential beneficiaries from all of these factors.

Peter Henry Hale, Vice President, Portfolio Manager, JB Convertible and High Yield Bond Hedge Fund and Ben Helm, Vice President, Portfolio Manager/Strategist, JB Convertible and High Yield Bond Hedge Fund Julius Baer Investments Limited, London.