A primer on convertible securities as a prelude to understanding Arbitrage and Market Neutral products; also, remembering Dr. Breslow and the quest for the ‘Fountain of Youth’By Edward Strafaci
Right from the outset, The Thoughtful Arbitrageur promised to educate its audience on Market Neutral products. In particular, we spoke about convertible, merger and options arbitrage. These are strategies that have always been popular due to the fact that their performance is “usually” not correlated to the general markets. With that said, we will begin by discussing convertible securities. In order to understand Convertible Arbitrage, a topic that will be revisited and studied iteratively, we first must understand how a convertible works. These hybrid stock and bond securities have confounded, yet fascinated, professional investors for decades. However, when they are reduced down to their essence, they are comprehensible.
Think of a convertible security as a bond with a call option attached to it. Though there are many flavors in the convertible universeâ€”domestic, offshore and exoticâ€”we will begin with the most basic and arguably the most popular, the “plain vanilla” convert. Regular, or “plain vanilla,” converts are exchangeable for a predetermined number of shares of the issuer, for a set period of time. Convertibles are issued as bonds or preferred shares. As with equity options the right to convert terminates at a set time after issuance, either through maturity or the issuer forcing the bonds conversion. As opposed to listed options that expire on a certain date, the issuer of a convertible can elect not to force the convertible holders to convert their bonds into shares. While in most cases it economically behooves the issuer to “force conversion,” there are times when the call option may be left open for a variety of reasons. These reasons will be discussed in future missives. However, factors like these are but one of the estimable vagaries that makes investing in these hybrids intriguing.
When describing any financing vehicle we need to look at it on a “quid pro quo” basis. In other words, the best way to view any business transaction is to look at it from both the buyer’s and seller’s perspective. One also needs to possess a conceptual understanding of the product. Too often there is an intellectual confusion in understanding finance when the learner gets too focused on the “math.” I have witnessed educated traders devote countless hours trying to perfect a model that can be bought off a shelf. All along they were missing the fundamental framework that drives the value of a convert. There are certain behaviors that cannot be modeled. Our feeling is that if you appreciate and master the concept you can conquer the subject. Let us look at a fictional convertible bond: The ABC 5% convertible bonds maturing in 10 years, call protected for three years, and pays interest semi-annually. The bond is convertible into 40 shares of ABC common which trades at $20 per share and has a dividend yield of 2%. Current and outstanding ABC 10-year bonds have an 8% yield to maturity.
Why would the issuer (ABC) finance using a convertible rather than a straight bond?
There are two key reasons an investment banker can sell ABC on the idea of floating a convertible bond:
1. Notice that ABC’s current 10-year debt trades at an 8% yield to maturity. By offering a convertible feature, ABC can finance at 5%! It should also be observed that if this bond trades at approximately 80 cents on the dollar, or $800 per $1,000 maturity amount, the yield-to-maturity will equal 8%. Thus, $800 is our theoretical bond floor, as our bond should hold value at that level, thus creating a put on our investment. This is known as a convertible’s “investment value.” Of course, this is subject to interest rate and credit risk. However, this put is a crucial feature to consider when purchasing a convertible security.
2. ABC may feel that its equity is approaching full valuation. Offering the convert allows ABC to sell its shares at a higher price. Since the bond is convertible into 40 shares of common stock, the conversion, or strike price of the call option is $25 per share. We derive this by dividing the $1,000 bond price by the conversion ratio of 40 shares or 1000/40 = 25. The bond is call protected for at least three years, therefore with ABC common currently trading at $20, we have a call option on 40 shares up 25% (25-20/20) with at least a three-year life. ABC can now issue shares at $25; it makes sense for either buyer or seller depending on your view of ABC. That in effect is a fair and sensible transaction since both issuer and purchaser can realize their respective goals.
What does the buyer receive?
The buyer of the ABC convert receives the aforementioned call option on ABC, and a significant yield advantage. This is by virtue of the fact that the buyer receives a 5% payout, and the additional comfort of a bond investment, as opposed to a 2% common yield. Traditional convert owners calculate this yield advantage in a payback period, where their yield advantage earns back the call premium on the bond, when valuing a convertible. The buyer also enjoys a theoretical put on his investment by virtue of the bonds “investment value.” An investor who believes in the upside of ABC, and is seeking yield, will embrace this type of security.
Again, we will amplify this product in future pieces. We will also categorize and explain the many and varied nuances and caveats, one encounters when purchasing these hybrid creatures. At the risk of overburdening you, we will conclude our first convertible lesson. Our next piece will deal with the cautions one must consider when opting for a convertible investment. This will set the stage for understanding the “Convertible Arbitrage” and our entrÃ©e into the world of market neutral investing. We are passionate about sharing these thoughts with our readership. Not knowing the possibilities and mechanics of arbitrage and its components is like shopping in the supermarket and only looking at a portion of the shelf space. Investing is challenging enough and there is no need to leave an additional advantage to others.
Who is Dr. Breslow and why are we speaking about him?
In our mindlessly hypercompetitive world, even longevity has become an obsession. There are those who view a long life as enviable without ever asking about what a person represented during that life span. Please do not get us wrong, a healthy lifestyle is essential and should be one of life’s goals. Nonetheless, a well-rounded complete life, full of all the good and happiness that was intended for us, should be our first priority. With that thought in mind, let us take a moment to remember Dr. Lester Breslow.
Dr. Breslow died last week at the ripe old age of 97. His New York Times obituary was titled “Lester Breslow, Who Linked Healthy Habits and Long Life, Dies at 97″. He empirically showed that longevity was linked to seven habits tied to moderation. We adore a simple, yet profound idea such as this, since that is the making of genius.
Dr. Breslow who served many presidential administrations came from a humble background yet rose to prominence. He stressed social action, as well as, science to improve people’s lives. The following quote from his obituary summarizes his philosophy:
“In 1952, President Harry S. Truman appointed Dr. Breslow director of a commission to assess the nation’s health care. The panel’s report emphasized that people make their own health choices but ‘exercise them mainly under social influences.’
“In 1969, as President of the American Public Health Association, he said the public health profession must go beyond issuing scientific reports and suggest social actions to improve people’s lives. “In the long run, housing may be more important than hospitals to health,” he said.”
What stunned the public health world was Dr. Breslow’s “ground-breaking” Alameda County study that he supervised as a Director of the California Public Health Department. In it, he definitively linked longevity to the following behaviors:
- Do not smoke.
- Drink in moderation.
- Sleep seven to eight hours per night.
- Exercise, at least moderately.
- Eat regular meals.
- Maintain a moderate weight.
- Eat breakfast.
As we mentioned, simple yet genius and all based on an important fundamental concept â€¦ temperance mixed with some discipline. This is wise advice indeed regarding health, investing and life. Rest in Peace Dr. Breslow.
Until the next time â€¦ The Thoughtful Arbitrageur.
Edward Strafaci is not an investment adviser. Nothing he writes should be construed as investment advice or an endorsement of any particular security. From time to time, a family trust with which he is associated may have positions in the securities he writes about. When it does, he will tell you. What he writes is meant to inform and in some cases to entertain and amuse. HedgeWorld’s Alternative Reality is not an investment advisory site. As a general rule you should not take investment advice from blogs, anyway. Consult a financial professional for investment advice, not a blog.