Hedged Convertibles: 10 Reasons Why

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1. Capitalize on ConvexityA convertible bond is a fixed income security that gives its holder the option to convert it into a predetermined number of equity shares in the same company.

This option creates an asymmetric return profile by which investors can, in rising stock markets, participate in equity upside through the bond’s equity option, but in falling stock markets, benefit from the bond’s fixed income features.

In other words, convertible securities offer investors the ability to capitalize on the potential benefits of both fixed income and equity investments simultaneously (i.e., the income and principal repayment associated with bonds, combined with the growth potential of stocks).

Convertible bonds are designed to act like a stock when the underlying equity rises and like a bond when it falls

Con

vert

ible

Bon

d Pr

ice

Fixed Income Characteristics Hybrid Characteristics Equity Characteristics

Convertible Bond Price Curve

Conversion Value of the Stock

Current Stock Price

Par (100)

Bond Floor

For illustrative purposes only.Source: Lazard

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2. Increase Downside ProtectionWhile the fixed income features of a convertible bond can provide income and reduced risk to bondholders, the additional use of hedges can increase downside protection.

Within Lazard’s hedged convertibles strategies, long convertible bond positions are paired with short stock positions in the same company. These position-level hedges are assigned to further reduce risk in down markets, while also serving as a hedge against the issuer’s credit exposure.

3. Monetize Market VolatilityHedging the long convertible bond with a short stock position can not only increases downside protection, but also serves as a source of returns.

In rising markets, the long bond position is expected to gain more than the short stock position loses due to the convertible’s asymmetric return profile. In falling markets, the short stock position is expected to gain more than the long bond positions loses.

The more frequent, and the larger the move of the underlying stock (i.e., the more volatile), the greater the potential profit that hedged convertibles strategies can extract.

This source of return, also known as volatility yield, is unique to hedged convertibles.

The convertible bond’s asymmetric return profile provides the ability to generate returns in both up and down markets

Long Convertible Bond Position

Short Stock Position

1

1234

2

3

4

Standard Deviation Standard Deviation ($) PnL (Std Dev) PnL ($)

1 $1 $12 $1

2 $2 $22 $4

3 $3 $32 $9

4 $4 $42 $16

For illustrative purposes only.

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4. Increase Return PotentialThe ability to monetize periods of market volatility allows for better return potential can be compared to traditional fixed income investments, such as high yield or investment grade credit.

Importantly, this enhanced return potential is made possible with fewer dollars at risk because of the stock hedge (long bond positions are paired with short stock positons), as opposed to high yield or investment grade credit in which return potential is unhedged.

5. Protect against Rising Interest RatesThe average duration of the convertible securities asset class is approximately two years. This compares to approximately four years and seven years for high yield and investment grade credit, respectively.

In addition to the low duration of the asset class, convertible securities have historically outperformed traditional fixed income in periods of rising interest rates.

Hedged convertible bonds typically provide greater return potential with fewer dollars at risk

0

200

400

600

800

Non-IGConverts5

ConvertsAverage4

IG Converts3High-Yield2Investment-Grade1

Credit spread over LIBOR (bps)

135

408

137

585

788Sources of Return:CouponAccretion

Risk Taken:- Credit - Duration

Sources of Return:Coupon + short stock rebateAccretionVolatility YieldRisk Taken:- Credit (Approx. ½ HY)- Duration (Approx. ½ HY)

As of 30 September 2019.

1 Source: Bank of America US Corporate Index (C0A0)

2 Source: Bank of America High Yield Master II Index (H0A0)

3 The IG Converts current implied credit spread figure is a straight average calculated by the portfolio team. This figure includes bonds rated by a credit agency as BBB or above OR unrated bonds with an implied credit spread of less than 500 bps.

4 The Converts Average current implied credit spread figure is a straight average calculated by the portfolio team. This figure excludes bonds of companies considered to be in default OR bonds priced below 30 OR bonds with less than two points of premium.

5 The Non-IG Converts current implied credit spread figure is a straight average calculated by the portfolio team. This figure includes bonds rated by a credit agency as BBB- or below OR unrated bonds with an implied credit spread of greater than 500 bps.

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6. Reduce Volatility of ReturnsThe use of hedges reduces the volatility of returns for hedged convertibles strategies as compared to long-only convertibles, traditional fixed income, and equities.

7. Access Differentiated AlphaMany convertible bond issuers are small- to mid-cap growth companies, which tend to be capital hungry and think flexibly about their capital structures, they are often willing to engage in discussions surrounding alternative ways to meet their debt obligations and finesse their capital structures (i.e., special situation trades).

These types of negotiated outcomes, which are mutually beneficial for both the issuer and investors, tend to change over time as a function of the broader market environment.

This life cycle allows for a consistent and repeatable source of alpha, one which supplements the traditional drivers of return in the space (hedged credit and equity volatility), and creates a strategic approach to hedged convertibles investing.

Life cycle of special situations and events provide consistent and repeatable source of alpha

2000-2002Credit Play

2003-2006Equity/Credit Play

2007-2008Volatility Play

2009-2010Credit Play

2011-2014Equity/Credit Play

2015Volatility Play

2016-2019Equity/Credit Play

• Buybacks• Restructurings• Tenders

• Flushes• Exchange Offers• M&A• Technical Defaults

• Buybacks• Default/

Distressed

• Buybacks• Restructurings

Tenders

• Flushes• Exchange Offers• M&A

• Re�nancings• Default/

Distressed

• Flushes• Exchange Offers• M&A

S&P 500 [LHS]

High Yield Spread Change [RHS]

(%) (%)

-24

-12

0

12

24

20192018201720162015201420132012201120102009200820072006200520042003200220012000-80

-40

0

40

80

20192018201720162015201420132012201120102009200820072006200520042003200220012000

As of 30 September 2019

Highlighted periods outlined above are subjective and were determined by the portfolio team based on its view and understanding of historical events.

Source: S&P 500 Index, Bank of America High Yield Master II Index

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8. AddDiversificationBenefitsThe ability to benefit from increased market volatility accounts for much of the diversification benefits of hedged convertible securities over other asset classes.

Lazard’s differentiated approach of focusing on special situation and event-driven trades is often uncorrelated to opportunities in traditional credit markets.

9. ExpandEfficientFrontierThe ability for hedged convertibles to provide increased return potential, with reduced risk and a reduced volatility of returns, means that introducing hedged convertibles to a traditional fixed-income or equity allocation can expand the efficient frontier of a well-diversified portfolio.

Hedged convertibles outperform traditional bond and equity allocations with less risk

2.5 4.5 6.5 8.5 10.5 12.5 14.5 16.5 18.5 20.5 22.5

3

4

5

6

7

8

9

Annualized Volatility1 (%)

Bond 100%

Stock 100%

Annualized Return (%)

Hedged Convertibles2 100%

Stock and Bond Long-Only Convertibles and Bond Long-Only Convertibles and Stock

Hedged Convertibles and Bond

Long-Only Convertibles 100%

Hedged Convertibles and Stock

As of 30 September 2019

1 Based on daily returns.

2 Performance represents that of the Rathmore strategy and is presented net of fees, including a 1.5% management fee and 20% incentive fee. The performance quoted represents past performance. Past performance is not a reliable indicator of future results.

Source: Lazard, Bloomberg. Stock: S&P 500 Index (SPX), Bond: BofA ML US Corporate & Government Index (B0A0), Convertibles: BofA ML Convertible Index (V0A0)

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10. Take a Contrarian ViewThe number of dedicated convertible bond hedge funds has decreased dramatically since the Global Financial Crisis.

In addition, with proprietary trading desks eliminated due to the Volcker rule, the current composition of the investor base is significantly skewed toward long-only investors.

This leaves little competition, and significant investment opportunities for hedged convertibles strategies.

HB32392

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