How Option Math Provides Insight into Convertibles
The terms alpha and beta are used often when discussing mutual funds and ETFs. Additional commonly uses phrases are standard deviation and Sharpe ratio, which just like alpha and beta, are important portfolio statistics. What most people probably don’t hear about when selecting investment products is delta – and with good reason. Delta is one of the terms collectively known as “the Greeks”, which are measures of option price sensitivity to various factors. For most investors in mutual funds or ETFs, this is not an applicable measure. However, for those investing in convertible securities products, it is a very relevant predictor of the fund’s behavior.
Figure 1: Convertibles combine bond and an option to convert the bond into a stock
This information is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results.
What does option pricing have to do with convertible bonds?
A convertible bond is a hybrid security that combines a bond with an option to buy the stock of that bond issuer. Upon exercising the option, the bond is converted into the equity at a predetermined conversion ratio, meaning the investor’s bond is now a stock. Issuers like convertible bonds because it allows them to issue bonds with lower coupons, and if converted, equity at a higher price than it is now (which is less dilutive to shareholders). Investors like convertible bonds because they participate in equity price appreciation, while retaining the fixed income characteristics of a coupon and maturity which may limit the degree of participation in stock price declines.
Figure 2: Hybrid behavior of a convertible bond is dependent upon delta
Source: BofA Merrill Lynch Global Research. This information is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results.
This is where delta comes in – the delta of convertible bonds ranges from 0 – 1 and reflects the sensitivity of the convertible bond price to the underlying equity price. For a portfolio with a delta of 0.7, you should expect the portfolio to pick up 70% of the underlying stocks upside. Convertible bonds can be broken out into three types of instruments from a delta perspective — the yield instrument segment, the total return instrument, and the equity alternative segment. The yield instrument segment consists of securities that are unlikely to be converted, and trade like bonds. As such, the equity value has little bearing on the convertible price since the security will remain a bond. Therefore, these securities have a low delta, typically less than 0.4. On the other end of the spectrum are equity alternatives – which are securities in which the underlying stocks are trading well above the conversion price. These options are “in the money”, have deltas greater than 0.8, and appreciate with the underlying stock to a greater extent than lower delta bonds. Conceptually, these bonds will probably be converted so it makes sense that their price movements track the stocks closely.
Why balanced convertibles are most attractive
The total return instrument consists of securities with deltas between 0.4 and 0.8 can be referred to as balanced convertibles, and we believe this is the most attractive part of the market. One of the most compelling reasons to invest in convertibles is the asymmetric return profile – the idea that you can get more of the upside and less of the downside, and this type of outcome may best be achieved through a balanced portfolio. Yes, higher delta securities will participate in more of the upside, but as illustrated in figure 2, the prices of the stock and equity alternative are parallel implying you will get most of the downside as well. Yield instruments won’t participate in much downside of the stock, but likely won’t give much in the way of equity appreciation either. Balanced securities can be expected to appreciate meaningfully with the stock, albeit not on a 1:1 basis, but hold up better than the stock should that stock decline in value. Investing in balanced convertibles provide a middle ground between equity alternatives and yield instruments which we think is the best of both worlds.
Adding an allocation to convertible bonds may be a great way to diversify a portfolio and change risk sensitivities, namely reducing equity beta. However, when choosing a convertibles manager, besides looking at usual return and portfolio statistics, it is important to look at deltas. By knowing the delta of their convertibles manager in conjunction with other characteristics, an investor may gain better insight into their portfolio and what expectations to set in terms of performance.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
Convertible Securities – Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. If an issuer stops making interest and/or principal payments, these securities may be worth less and the fund could lose its entire investment.
Alpha is the excess return (also known as the active return), an investment or a portfolio.
Beta is a measurement of the volatility, or systematic risk of a security or portfolio, compared to the market as a whole.
Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
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