Investors on Monaco’s financial market are seeking optimal security for their investments together with the best yield.
Today this is a delicate exercise, as it is a case of reconciling what are historically very low monetary rates with an uncertain macroeconomic climate in Europe correlated with public deficits. The one definite vector for growth is that of the emerging countries.
A regional pick-up in economic growth
Classes of assets have to be chosen on the basis of a number of parameters that are changing at different rates. Creating a strategy based on projected recovery times of interest rates is still risky. On the other hand, the regional pick-up in economic growth, the quality stamp of Investment Grade issuers and the anticipated return of increased volumes onto the market can constitute an opportunity. Another parameter is foreseeable: the continuation of volatility in a period of market growth. The acquisition of convertible bonds for part of a portfolio meets the need for both security and yield. It might be worth considering increasing the value of shares of several high quality issuers by limiting the risk of loss in the event of a drop in the price of such shares with insured yields. Classifying convertible bonds as a hybrid product could wrongly arouse reservations as a result of ignorance. These can easily be allayed by explaining the simplicity of the mechanism.
The yield of a convertible bond is slightly lower than that of a classic bond
For the record, a convertible bond is a classic bond accompanied by an option to convert at a price and up to a cut-off date set in advance. The benefits of this purchase option are offset by the fact that the yield of the bond is slightly lower than that of a classic bond. In return, the investor gains certain advantages; in the event of a decrease, the price of the underlying share (the value of the bond) serves as a lower limit that cannot be exceeded and limits the impact on the bond price of the drop in the share price. This security is valuable in a volatile market. In the event of an increase, there are no limits to the potential increase in the share price (the bond value). Convexity, which measures the performance of a bond in relation to a variation in the share price, is more favourable if the share rises than if it drops. The further a share price increases, the further the conversion premium decreases towards zero. The price of a bond will therefore increase at the same rate as that of the underlying share. At this point in time, the positive speculative aspect comes fully into play and the investor will chose the most opportune moment to exercise their purchase option and buy the shares at a price lower than the market price.
Constraints to be observed
- Select a high quality issuer (credit risk);
- Find so-called “Investment Grade” issuers in businesses that are preferably non-cyclic;
- Monitor changes in the price of the underlying share, its anticipated volatility and estimated future dividends, all of which will have an influence on the bond price.
These constraints can be delegated to mutual funds that have demonstrated their know-how in 2009.
Recourse to this type of product is also beneficial to the issuer. It enables him to raise loans at a reduced rate compared to bonds of the same class. At this time of extremely low rates, this advantage becomes still more attractive.
The convertible bond has two weaknesses that can influence its yield:
- the right price: quality balance from an issuer in a market that is out of sync;
- volatility purely as a result of the activity of third parties.
As with classic bonds, investors must monitor the quality of the issuer, changes in interest rates and the currency that will determine the price of the convertible bond. In addition, it might be possible for issuers to convert their debt by increasing their capital if their share price rises. Edgar in King Lear said “Ripeness is all”.
