A Meeting of Minds Wealth Management & Private Banking June 2016
Expert: Paris Karasso, Calamos International
It is difficult to allocate assets to negate the impacts of global events, but maintaining a balanced and flexible portfolio asset allocation can help. In that regard, convertibles have a role to play, which behaves like a fixed income holding in bad times, and an equity holding in good times.
- Predicting short-term investment outcomes is hard to do. There is no one indicator that is good for predicting short-term movements.
- Volatility is an inevitability of being in the market. It can be tempting to time markets and factors but this should make up a small portion of a portfolio.
- Asset diversification and risk management works.
- Convertibles provide an opportunity for investors to have flexibility and diversification at the heart of their strategies.
The roundtable discussion began with acknowledgement that there are numerous investment styles deployed to seek alpha and simultaneously reduce risk – price-driven, event-driven, asset class preference-driven, sector-driven and fundamentals-driven. Each of these styles has flaws, whether it is timing or flexibility or both.
The reality is that all these styles require asset diversification and risk management in order to deliver stable and safe returns.
One investment class worthy of consideration in this light is a convertible. Convertibles are corporate bonds with maturities of between five and seven years which come with an embedded option to exchange for equity if the company does well.
In that regard, they ‘behave like an equity when things go well and like a bond when things go down’. Convertibles are the only asset class with a skew which can convert to both upside and downside.
Yet the market for these investment products is not big. In fact at the current time, there are about USD300 billion in convertibles available with smaller players being the major distributors. Pre-crisis that figure was closer to USD500 billion where a lot of financial institutions issued them.
Technology and pharmaceutical players tend to issue convertibles now, as it is a relatively inexpensive way to raise capital. The price of them is based on three aspects – the price of the underlying asset, the spread and the volatility.
The difficulty seems to come when classing what asset bracket convertibles fall in to.
“There is a Merrill Lynch study which suggests it is its own asset class. Funnily enough, we know having spoken with Merrill Lynch, that in the past, their investment platform has flagged portfolios where convertibles have been used. Why? Because ironically, they have been coded as an equity holding – meaning the portfolio management tool has called the allocation in to question based on a client’s risk parameters.”
Concerns were expressed about what may happen in the event of a default or bankruptcy – where do convertible bond holders sit in the creditor line pecking order? Convertible bonds in that sense are considered as regular bonds, so holders would be the first in line.
Most present suggested that convertible bonds would be of interest – but for specific relationships.
“I think convertibles may be of interest to us on an advisery basis. Clients may come to us with questions about equity alternatives and convertibles may work in that regard. I can see value for certain kinds of clients.”
Indeed for some, there was doubt as to whether if you held a discretionary relationship, if you even needed to communicate your intentions to use convertibles within a client portfolio or otherwise.
“If you’re a discretionary manager, perhaps you don’t need to communicate with clients. It’s a simpler product to understand than a hedge fund – I’ve used these in the past. We bought a lot of these after 2008, because it was a fundamental issue in the market, which provided a very specific opportunity which doesn’t occur very often. We categorised it as ‘Other’ within risk management. We can add up to 20% of ‘Other’ in to an investment portfolio which is essentially anything that doesn’t fit.”
The bigger concern held by many of the delegates at the round table surrounded a lack of in-house expertise around convertibles as an investment product and how the asset class could be leveraged for end-client portfolios.
“We don’t have a dedicated in-house expert with relation to convertibles. We favour alternatives through hedge funds, although this wouldn’t sit in alternatives. We’d manage it through the fixed income/equity investment line.”
Ultimately, the decision to use convertibles requires wealth managers to have an appreciation of the product, a willing client base and strong portfolio and risk management services.
With only USD300 billion in convertibles available, the market is relatively small, but it does represent an opportunity for alpha generation in an era of low interest rates and a steady investment opportunity when market conditions are volatile.