Why are convertibles seen as a unique investment solution and often called hybrid securities?

Dagney Hollander

Q:

Dagney:

Convertible securities are unique.  They are bonds or preferreds that generally pay interest or dividends and, in addition, are convertible into a certain number of shares of the underlying equity.  A convertible bond is generally categorized as a fixed income instrument.  However, because of the conversion feature, they are sensitive to rising and falling equity prices.  Also, as the holder has the option to buy stock, their valuation is positively impacted by increased volatility in the underlying equity.  A convertible bond has interest rate sensitivity; however, it tends to be lower than a similar straight bond due to the conversion feature.   

A:

January 2015

Dagney Hollander,

Portfolio Manager ,
Hedged Convertible Team

Michael Opre,

Portfolio Manager ,
Outright Convertibles

Michael J. Opre, CFA

SSI manages convertibles on a hedged and an unhedged basis.  What are the key differences?

Q:

Dagney:

SSI's Hedged Convertible Income Strategy is an unlevered, low volatility, income alternative.  SSI selects positions with attractive income profiles and then hedges out the equity exposure by selling short shares of the underlying company's common stock.  In addition to income, the Strategy can benefit from capital gains from SSI identifying undervalued bonds which are expected to revert to fair value and profits generated by adjusted our short position as the bond's sensitivity to the underlying equity changes with movements in the common stock.  Heightened volatility in the underlying equity can improve the potential for the latter.  

Mike:

SSI's Outright Convertible Strategy (unhedged) is a conservative equity strategy.  In SSI's Outright Convertible Strategy, SSI buys convertible bonds, expecting to benefit from both the yield and the potential equity upside of the bond's call option.  Unlike SSI's Hedged strategy, which seeks Income without equity risk, the Outright Strategy does not hedge out the equity risk through short selling.

A:

In 2014, SSI's Hedged Convertible Income Strategy faced headwinds, while the Outright Convertible Strategy progressed with tailwinds.  Can you explain the difference and what were the key drivers?

Q:


Dagney:

While SSI's Hedged Convertible Income Strategy has historically performed well in most rising interest rates environments, the strategy can be affected by a sudden widening of credit spreads or interest rates.  In the first half of 2014, the Strategy was generating reasonably good returns, especially considering the low interest rate environment.  However, during the last four months of the year, there was a shock to the credit markets due to the severe decline in oil prices.  Many US E&P companies have expanded rapidly in recent years through the issuance of corporate debt securities, including convertibles.  Depending on the level of oil prices and the availability of credit, it was estimated that up to a quarter of these issuers faced a risk of default.  In response, investors began to require higher yields for the increased risk.  Energy and energy-related bond spreads rose sharply in September of 2014 and continued to drift wider over the next four months.  In response, our Team reduced energy exposure.   While this response was the appropriate risk control measure, the portfolio still declined during this time period primarily due to the overall widening of credit spreads and cheapening of the convertible market.

Mike:

Equity returns were the primary driver of convertible securities returns in 2014. The S&P 500 was up 13.7% in 2014 and other major domestic equity indices posted positive returns. This provided a tailwind for the Outright Convertible Strategy and overcame the relatively mild impact of widening credit spreads.  

A:

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A:

Ravi Malik, CFA

Ravi Malik, CFA

Portfolio Manager ,
Principal

The US Dollar Index is up strongly since the start of 2015, although a fair amount of the gain occurred in the first quarter.  The U.S. Dollar started rising in the middle of 2011, a trend that sharply accelerated in mid-Summer last year. The primary driver of the move was the sharp divergence in the monetary policy path in the US from the path of monetary policy in other major developed economies such as Europe and Japan.  Starting in the second half of 2014, the European Central Bank (“ECB”) cut interest rates to fresh record lows to combat deflation risks and embarked upon an asset backed security purchase program. This morphed into a full-fledged Quantitative Easing (“QE”) announcement in January 2015 that involves buying government bonds.  Japan has had an ongoing QE program since April 2013. By contrast the US ended QE in October 2014 and is talking about a gradual normalization of interest rates by raising them above the current level of zero.

What is the likely impact of a rising Dollar on the US economy and specific US companies?

Q:

A rising US Dollar impacts the economy in a multitude of ways and has wide investment implications.  A rising dollar lowers the prices of imported goods and services into the US.  In particular, it has lowered the price of energy imports and commodities.  The result is lowered inflation expectations that have allowed the Federal Reserve to put off the impending increase in the Fed Funds rate and have kept interest rates low, supporting investment and asset prices.  Low energy prices are a tax cut for consumers and lower commodity prices benefit about every manufacturing enterprise.  

US multinational companies are most vulnerable to a rise in the Dollar, as sales generated in another depreciating currency will yield lower returns after the transaction is converted back to the US Dollar. We have witnessed this in earnings calls and reports this year – that is, some multi-national companies are stating that earnings are negatively impacted by the rising Dollar. When investing in companies which generate meaningful sales from overseas, it is important to determine the foreign currency translation effect. We certainly incorporate this analysis into our investment process. The  impact on revenue and earnings is somewhat offset by the fact that many US companies have expenses associated with imported products and services, including raw materials and labor. This may have a positive impact on the income statement.

Finally, also bear in mind that while in the short term there are generally both positive and negative consequences of a rising Dollar, over the longer term a strong currency is a sign of economic and financial strength. The reverse is also true – a rapidly declining currency can be highly problematic for nations due to the potential for out of control inflation. In summary, while the short term impact of a rising Dollar may lower revenue and earnings for multinational companies, there are both short term and long term benefits from US Dollar strength.

A:

Q:

September, 2015

Ravi, what initially drove the rise in the U.S. Dollar?