M&G Global Convertibles Fund

Transcription

1 M&G Global Convertibles Fund A guide to the convertibles asset class January 2013 Fund manager Léonard Vinville In this note we discuss the characteristics of the convertibles market, explaining how convertibles behave, the benefits of the asset class and the drivers to performance. We also detail M&G s experience and expertise within what we believe is a very attractive investment area. Contents The benefits of convertibles Introduction to convertibles Characteristics of convertibles Glossary of technical terms Drivers of the value of a convertible How share price determines the equity sensitivity of a convertible A well diversified market M&G s expertise in convertibles The benefits of convertibles Convertibles provide investors with a combination of the safety of investing in bonds and the potential appreciation of investing in equities. Due to their hybrid nature, convertibles offer an extremely appealing risk-reward profile and, as such, can be an important addition to a portfolio in order to improve diversification and boost its risk-reward profile over the long term. Introduction to convertibles Convertible securities are not a new asset class, having been around for more than 150 years. The first issuers of convertibles were railroad companies in the US and the main reason why this type of debt was issued and why it still is today is that convertibles are a cheaper source of funding, which can be used to improve a company s balance sheet profile. As such, convertibles are simply a form of debt issued by a company, with all the characteristics of a corporate bond, such as regular interest payments and fixed maturity dates. However, since they carry the additional feature of the opportunity to convert into a certain number of the issuer s shares, they generally pay a lower interest rate, or coupon, than a comparable corporate bond. Convertibles offer investors a source of income and the stability of holding a bond while also giving access to higher, equity-like, returns via the option to convert into shares. Characteristics of convertibles The easiest way to understand a convertible is to break it down into its component parts and consider it as a bond combined with a call option on the issuer s equity. The debt portion provides protection and income, while the option gives upside potential. The combination of the two elements creates a return profile that is termed asymmetric, meaning that the convertible participates more in an equity price rise than in an equity price fall.

2 Example Consider a convertible with a nominal value of 1000, carrying a 2% coupon and which can be converted into 500 shares of the issuer, ABC plc. If the underlying shares of ABC trade at 2, the value of the shares received on conversion, or parity, would be If the ABC share price increased to 2.20, parity would increase to 1100 and the convertible bond would be worth at least If, on the other hand, the ABC share price fell to 1.80, parity would drop to 900. However, the convertible would still be worth 1000 because that is the amount that ABC will have to repay as debt. Glossary of technical terms The terminology used to describe some of the characteristics of convertible bonds can be very specific to the asset class. Some of the most frequently used terms are defined below. CONVERSION RATIO: The number of shares the holder will receive upon conversion. The rate is set at issue but can increase if the convertible has dividend protection or takeover protection features. CONVERSION PRICE: The strike price, at which the bond can be converted into shares. It is calculated from the conversion ratio (eg if a 1000 convertible bond converts into 500 shares, the conversion price will be 2). When a convertible is issued, the conversion price is generally around 25-40% above the prevailing equity price, with the difference being known as the CONVERSION PREMIUM. PARITY: The conversion value, or amount that the shares received would be worth if the convertible were converted today. It is calculated as the current share price multiplied by the conversion ratio. BOND FLOOR: The value of the bond component of the convertible. It is the present value of the coupon payments and redemption amount and can change according to moves in credit spreads and interest rates. If the convertible reaches final maturity, the bond floor will be par. DISTANCE TO THE BOND FLOOR: The value of the option embedded in the convertible. This should be the amount that can be lost if the equity price falls and the convertible trades at its bond floor. DELTA: The sensitivity of the convertible to movements in the underlying equity price. For example, if a convertible has a delta of 50% then, for every 1% movement in the share price, the convertible price will move 0.5%. CONVEXITY: A measure of the asymmetry of returns of a convertible. A convertible is convex if its price moves more on the upside than on the downside given an equal percentage move in the share price. As an example, if we assume that when the underlying share price rises by 30%, the convertible price rises 15% but, when the share price falls by 30%, the convertible price drops 10%, then convexity is equal to 15%-10% = 5%. PAR: The nominal value of the convertible, or the amount that the issuer will repay at maturity. This is usually 1000, whether in sterling, dollars or whichever currency the convertible is denominated in. Convertible prices are generally quoted as a percentage of par, meaning that par is 100%. In the event of a default, a holder may receive less than par.

3 Drivers of the value of a convertible The value of a convertible is determined by a number of factors. Some affect the bond element of the convertible, while others will cause a change in how much the conversion option is worth. The table below illustrates how some of the most common features of the stockmarket would change the value of the bond part of a convertible, the conversion option and the convertible as a whole. Drivers of the value of a convertible Factor Share price rises Credit spread tightens Possible reason Company s profitability improves during the year Credit quality of the issuer improves Effect on bond element Effect on call option Effect on convertible None Positive Positive Positive None Positive Interest rates rise Inflation increases Negative Positive Negative Volatility rises Market uncertainty increases None Positive Positive Dividends are paid Regular or exceptional dividends are paid to shareholders None Negative Can be positive* Issuer is taken over Consolidation within industry sector None Positive Positive** * Only positiv e if the conv ertible has a div idend protection f eature. ** If the conv ertible has a takeov er protection f eature, the positiv e ef f ect can be greater f or the conv ertible than the equi ty. How share price governs the equity sensitivity of a convertible Convertibles exhibit different kinds of price behaviour depending on whether the underlying share price is above or below the conversion price. The bond component of a convertible s valuation is the more stable element of an assessment of worth, while the value of the embedded option is more changeable. The relationship of the prevailing share price to the conversion price governs the value of the call option and hence the sensitivity of the convertible to moves in the share price that is, how much delta the convertible will exhibit. Low share price If the share price is a long way below the conversion price, the call option will be worth very little and relatively unaffected by moves in the share price. The option is termed out of the money. In these circumstances the convertible will behave similarly to a corporate bond. In other words, the convertible demonstrates bond like price behaviour.

4 Share price close to conversion price If the share price rises and approaches the conversion price, the option becomes more valuable and the sensitivity to share price movement increases. The option is then said to be at the money. If the underlying equity price continues to improve, the value of the convertible will also rise. However, if the share price weakens the convertible bond s value will fall, but at a slower rate, since the option will move quickly out of the money, reducing the sensitivity to share price moves. Convertibles showing these characteristics are known as balanced and offer the highest convexity, as gains are usually larger than losses for a given share price movement. Balanced, or atthe-money, convertibles have the most attractive risk reward profile. High share price If the underlying share price moves a long way above the conversion price, so that it is in the money, the embedded option becomes more valuable and very sensitive to equity movements. As a consequence, the convertible will behave like equity and mirror the movements in the underlying share price. Between launch and redemption (or conversion) a convertible can move in and out of the different categories. Therefore, it is extremely important to manage convertible exposure from a risk perspective. Typical price behaviour of a convertible Bond like: Option is out of the money Balanced: Option is at the money Equity like: Option is in the money Source: M&G, December 2012

5 The convertibles market Although the convertibles universe is relatively small compared with the straight corporate bond market, with a size of approximately $485 billion as at the end of 2012, it is well diversified in terms of geographic and industry exposure. Some 44% of the market is in the US, 26% in Europe, 6% in Japan and the remaining portion in other Asian markets and South Africa. Convertibles are issued by companies from the whole spectrum of industry sectors, although the most exposure is to technology hardware and equipment, pharmaceuticals and biotechnology, oil & gas producers and real estate. (Source of data: UBS, MACE Advisors, as at 31 December 2012.) The convertibles market offers interesting exposure to the credit and equity profile of numerous mediumsized companies and, overall, provides many opportunities for stockpicking. M&G s expertise in convertibles M&G has a long history of investing in convertibles. Leonard Vinville joined the group in 2002 to manage Prudential s allocation to this asset class and, following the success of the strategy, the M&G Global Convertibles Fund was launched in July Today the M&G Global Convertibles Fund can rely on the knowledge and skills of a strong team of four, including two dedicated equity and credit analysts and one investment specialist. Key to the investment performance of the fund is a bottom-up, global approach to stockpicking based on the fundamental analysis of the underlying equity and credit characteristics as well as the technical aspects of convertibles. M&G Global Convertibles team structure Research and analysis M&G Convertibles team Dedicated portfolio analytics and dealing Industry analysts Equities Equities team Public credit research Fixed Interest Léonard Vinville (16 years experience) Fund manager David Romaní (8years) Dedicated convertibles analyst Convertibles and derivatives dealing desk Risk management team Fixed Interest Retail Fixed Interest team Yannis Karachalios (8years) Dedicated convertibles analyst Multi Asset team Maria Municchi (4years) Investment specialist Portfolio construction & risk team Equities Source: M&G as 31 December 2012.

6 Prices may fluctuate and you may not get back your original investment.this document is designed for investment professionals use only, not for onward distribution to any other person or entity. FOR USE IN THE UNITED KINGDOM AND THE COUNTRIES MENTIONED BELOW : For Switzerland: Distribution of this document in or from Switzerland is not permissible with the exception of the distribution to qualified investors according to the Swiss Collective Investment Schemes Act, the Swiss Collective Investment Schemes Ordinance and the respective Circular issued by th e Swiss supervisory authority ("Qualified Investors"). Supplied for the use by the initial recipient (provided it is a Qualified Investor) only. In Spain the M&G Investment Funds are registered for public distribution under Art. 15 of Act 35/2003 on Collective Investment Schemes as follows: M&G Investment Funds (1) reg. no 390, M&G Investment Funds (2) reg. no 601, M&G Investment Funds (3) reg. no 391, M&G Investment Funds (5) reg. no 972, M&G Investment Funds (7) reg. no 541, M&G Investment Funds (8) reg. no 1100, M&G Investment Funds (9) reg. no 930, M&G Global Dividend Fund reg. no 713 M&G Dynamic Allocation Fund reg. no 843, M&G Global Macro Bond Fund reg. no 1056 and M&G Optimal Income Fund reg. no 522. The collective investment schemes referred to in this document (the "Schemes") are open-ended investment companies with variable capital, incorporated in England and Wales. In the Netherlands, all funds referred to are registered with the Dutch regulator, the AFM. This information is not an offer or solicitation of an offer for the purchase of investment shares in one of the Funds referred to herein. Purchases of a Fund should be based on the current prospectus. The prospectus, Key Investor Information Document (KIID), the Instruments of Incorporation, annual report and subsequent semi-annual report, are available free of charge, in paper form, from the ACD: M&G Securities Limited, Laurence Pountney Hill, London, EC4R 0HH, GB, or one of the following: M&G International Investments Limited, German branch, Bleidenstraße 6-10, D Frankfurt am Main, the German paying agent J.P. Morgan AG, Junghofstraße 14, D Frankfurt am Main, the Austrian paying agent, Raiffeisen Bank International A.G., Am Stadtpark 9, A-1030 Wien, the Luxembourg paying agent, J.P. Morgan Bank Luxembourg S.A., European Bank & Business Center, 6 c route de Treves, 2633 Senningerberg, Luxembourg, the Danish paying agent, Nordea Bank Danmark A/S Issuer Services, Securities Services, Hermes Hus, Helgeshøj Allé 33, Postbox 850, DK-0900, Copenhagen C, Denmark, Allfunds Bank, Calle Estafeta, No 6 Complejo Plaza de la Fuente, La Moraleja, 28109, Alcobendas, Madrid, M&G International Investments Limited, 34 Avenue Matignon, 75008, Paris, France or from the French centralising agent of the Fund: RBC Dexia Investors Services Bank France. For Switzerland: Please refer to M&G International Investments Ltd., Bleidenstraße 6-10, D Frankfurt am Main or, for Sweden, from the paying agent, Skandinaviska Enskilda Banken AB (publ), Sergels Torg 2, Stockholm, Sweden. For Italy, they can also be obtained from one of the appointed paying agents, details of which can be found by visiting the contact section on the following website: Before subscribing you should read the prospectus, which includes investment risks relating to these funds. This financial promotion is issued by M&G Securities Limited and M&G International Investments Ltd. Both are authorised and regulated by the Financial Services Authority and have their registered offices at Laurence Pountney Hill, London EC4R 0HH. M&G International Investments Ltd. is also registered with the CNMV in Spain. FOR USE IN ALL OTHER JURISDICTIONS NOT MENTIONED ABOVE (EXCLUDING THE USA): This financial promotion is issued by M&G International Investments Ltd. Registered Office: Laurence Pountney Hill, London EC 4R 0HH, authorised and regulated in the United Kingdom by the Financial Services Authority. M&G International Investments Ltd and the funds referred to in this document may not be authorised, recognised or regulated by the local regulator in your jurisdiction. This information is not an offer or solicitation of an offer for the purchase or sale of investment shares in one of the funds referred to herein.s1137, January 2013.