Deutsche Morgan Grenfell Convertibles

Date
Convertibles as Equity 8 June 1998

Alternatives
Equity Outperformance With Convertibles
Figure 1: Convertible ’Switching’ Strategy Leads to Equity Outperformance
Switch
110.0 Switch

100.0

90.0

80.0

70.0

Switch
60.0
Switch Switch

50.0 End Strategy

40.0

30.0

20.0
Nov-94 Jan-95 Mar-95 May-95 Jul-95 Sep-95 Nov-95 Jan-96 Apr-96 Jun-96 Aug-96 Oct-96 Dec-96 Feb-97 Apr-97 Jun-97 Aug-97 Nov-97 Jan-98 Mar-98

Convertible Parity

• Strong equity markets mean that many convertibles around the

world are trading at a low premium to the shares into which
they are convertible.
• Convertibles can be excellent alternatives to equities where they
have sufficiently high yield, with a short ’breakeven’.
• Convertibles are also very useful for ’risk-adjusted’ equity
exposure, offering upside participation to a stock with
downside protection if things go wrong.
• We show a simple example of XYZ Corp 6% 2003 $ to illustrate
these points.
• We also show how equity investors can utilise a ’switching’
strategy of using convertibles when the premium is low and
equities after the premium has expanded.
• Deutsche Bank screens all the world’s convertible markets daily
for equity opportunities in convertibles.

Jeremy Howard
Tel: (+44) 171 545 2361

Rob Weir
Tel: (+44) 171 545 2362

Robert Breslin
Tel: (+44) 171 545 2363
Deutsche Morgan Grenfell Convertibles as Equity Alternatives 8 June 1998

1. Convertibles as Equity Alternatives

Strong equity Given the recent strong performance of equities in most of the world’s major
markets, many convertible bonds are now trading at small or zero premiums to
performance
their ’parity’ values (the value of the shares into which they can be converted).
strengthens the case for
There are even some convertibles trading at a discount to parity. Low-premium
convertibles
convertibles offer equity funds an opportunity to retain exposure to an
underlying stock, while protecting their downside if the stock does not perform as
well as anticipated.

A simple example To illustrate how this works we shall use a very simple example.

XYZ Corp 6% 2003 $ convertible is trading ’in the money’, with an attractive
profile for a potential equity switcher. At 135 offered, it is trading on just a 3.85%
premium to the value of the XYZ Corp shares into which it can be converted
(worth 130 per bond).

Table 1: XYZ Corp 6% 2003 $

1 Nominal amount $1,000

2 Price (% of nominal) 135
3 Coupon 6%
4 Conversion ratio (shares per bond) 10
6 Conversion price (price at which share are ’bought’) $135
7 Current stock price $130
8 Parity ((stock price x conversion ratio) / nominal) 130%
9 Premium ((convertible price - parity) / parity) 3.85%
10 Running yield (coupon / convertible price) 4.44%
11 Dividend yield 1.50%
12 Hard call protection (issuer cannot call bond) Until 2002
13 Bond value (value of convertible as a straight bond) 90%

2. ’Breakeven’ Analysis

Extra yield can make If a fund manager wanted to retain exposure to XYZ Corp shares for a long
convertibles an obvious period of time (the stock may be a significant component of a benchmark index,
equity alternative for example), the convertible is probably a better alternative than the shares.

This is because the convertible will ’pay for itself’ via its extra yield if it is held for
any reasonable length of time (see Table 1).

Consider two different ways of taking exposure to XYZ Corp shares:

1
10 shares bought via convertible $1,350
10 shares bought at market $1,300
Cash premium paid for convertible $50

1
Remember that almost all convertibles are ’American’ style, in that they may be converted into
the underlying shares at any time.

2 European Convertibles
8 June 1998 Convertibles as Equity Alternatives Deutsche Morgan Grenfell

But the convertible will give significantly greater yield than the underlying stock.

Table 2: Yield Advantage of the Convertible ($1,350 invested)

Period Cash Dividend Coupons on Cumulative Yield
on Shares ($) Convertible Advantage on
($1,350x1.5%) ($) Convertible ($)
1 year 20.25 60 39.75
2 years 40.50 120 79.50
3 years 60.75 180 119.25
4 years 81.00 240 159.00
5 years 90.25 300 209.75

’Breakeven’ explained The length of time it takes to repay the cash premium paid to own the same
number of shares via the convertible is called ’breakeven’. If breakeven occurs
before the issuer can call the bond it should be attractive to equity investors.

Breakeven = Cash premium / annual cash yield advantage of convertible

Breakeven = $50 / $39.75

= 1.26 years

The convertible repays the premium paid to own it after only 1.26 years. If the
investor has a longer time horizon than this the convertible is probably a more
attractive way to take exposure to the shares.

3. Risk Adjustment

’Risk adjustment’ of As well as offering extra yield, convertibles also offer equity investors the chance
convertibles gives to adjust their risk profile. This is because a convertible bond, having a fixed
asymmetric exposure to cash redemption at maturity, will not be exposed to all of a stock’s downside.
underlier The convertible will be supported as the stock price falls by its value as a straight
corporate bond (’bond floor’).

This is shown graphically in Figure 2.

Convertibles 3
Deutsche Morgan Grenfell Convertibles as Equity Alternatives 8 June 1998

Figure 2: ’Risk Adjustment’ Demonstrated

164
Convertible Price
135

convertible price
120 162.5

130

Bond Floor
97.5
Parity

stock price

Three stock price In order to show how this ’risk adjustment’ works we will consider three stock
scenarios price possibilities over one year:

1. Stock price up 25%

2. Stock price static
3. Stock price down -25%

The return of $100 invested in the stock or the convertible is shown in the tables
below.

Table 3: Stock Price Up 25% Over One Year

Old Price New Price Capital Gain Income Total Return

($) ($) /(Loss) ($) ($)
Stock 130 162.5 32.5 1.5 26.2%
Convertible 135 164.0 29.0 4.4 24.8%

1. The convertible participates in 94.7% of the upside equity return.

Table 4: Stock Price Unchanged Over One Year

Old Price New Price Capital Gain Income Total Return

($) ($) /(Loss) ($) ($)
Stock 130 130 0 1.5 1.5%
Convertible 135 135 0 4.4 4.4%

2. The convertible participates in 293% of the static equity return.

4 Convertibles
8 June 1998 Convertibles as Equity Alternatives Deutsche Morgan Grenfell

Table 5: Stock Price Down 25% Over One Year

Old Price New Price Capital Gain Income Total Return

($) ($) /(Loss) ($) ($)
Stock 130 97.5 (25.0) 1.5 -23.5 %
Convertible 135 120.0 (11.1) 4.4 -6.7 %

3. The convertible participates in just 28.2% of the stock’s downside return.

Of course, if these scenarios were run over a longer period of time (say two or
even three years) the convertible upside/downside participation would be even
more impressive due to the superior yield on the convertible.

4. Locking in Equity Gains

Equity gains can be If an equity has had a good rally, an investor can protect some of the capital gain
protected with by switching into a convertible.
convertibles
As an example we will use the XYZ Corp share price. If the stock rallies by 30%,
perhaps on a rumour of a takeover or something of that kind, the fund manager
who is long the stock but who does not necessarily believe the rumour can ’take
some money off the table’ by switching into the convertible.

By staying long the stock the investor is exposed to losing all of his gains if the
stock falls back down to its original level. However, by switching into the
convertible, the investor only loses 9.6% of the higher amount if the stock
retraces its steps (as the manager expects).

Switch Into Convertible Locks in Equity Gain

Stock $100 $130 $100

+30.0% -23.0%

Bond $135 $122

-9.6%

Switching from the equity into a convertible after a big equity rally means that
the investor will participate in any further upside but will not suffer the same
degree of loss if the stock surrenders its gains.

5. ’Playing the Premium’

’Switching’ between By ’switching’ between holding a stock or a convertible it is possible to

stock and convertible is outperform ’buy and hold’ strategies of either stock or bond. This is the most
the best way to use advanced use of convertibles by equity funds.
convertibles
This strategy does not even require an investor to pick inflection points. We
analysed what would have occurred if an investor had used a purely automatic
’switching’ strategy to take exposure to Samancor (South African mining
company) over the period 1994 to 1998.

Convertibles 5
Deutsche Morgan Grenfell Convertibles as Equity Alternatives 8 June 1998

The returns of the three possible strategies are shown in the table below, and
graphically illustrated in Figure 1.

The strategy was simply:

Long the convertible = when premium is less than 5%

Long the stock = when premium is over 30%
Sell entire position = when premium is over 50%

Table 6: Switching Between Convertible and Stock

Strategy Total Return (incl. Yield)

Buy and hold stock 10.4 %
Buy and hold convertible 7.4 %
Switching between bond and the stock 64.0 %
Source: Deutsche Morgan Grenfell Estimates
Samancor 7% 2004
$demonstrates
Figure 3: ’Switching’ Strategy Empirically Demonstrated
outperformance of 7
Switch
’switching’ strategy 110.0 Switch

100.0

90.0

80.0

70.0

Switch
60.0
Switch Switch

50.0 End Strategy

40.0

30.0

20.0
Nov-94 Jan-95 Mar-95 May-95 Jul-95 Sep-95 Nov-95 Jan-96 Apr-96 Jun-96 Aug-96 Oct-96 Dec-96 Feb-97 Apr-97 Jun-97 Aug-97 Nov-97 Jan-98 Mar-98

Convertible Parity

It is clear that the ’switching’ strategy automatically gives investors exposure to

the stock after big stock price falls and exposure to the much more defensive
convertible after stock rallies.

6. Other Reasons to Use Convertibles as Equity Alternatives

Other reasons for using • Liquidity - The convertible may be more liquid than the underlying equity. In
convertibles some cases, especially for dollar-denominated convertibles in the emerging
markets, the bond may trade in greater size and on tighter spreads than the
stock.

• Better Use of Capital - Insurance funds and certain financial institutions have
lower risk-based capital requirements for bonds than stocks. For this reason,

6 Convertibles
8 June 1998 Convertibles as Equity Alternatives Deutsche Morgan Grenfell

the convertible may allow the institution to take the same level of exposure to
a stock, without tying up as much of its balance sheet in the process.

• Asset Allocation - Funds that need to reduce equity exposure to meet broader
goals of asset allocation strategy can make that reduction via convertibles,
without surrendering the potential for upside performance.

• Equity Exposure With Extra Yield - Balanced, income and fixed income funds
wanting to achieve limited exposure to equities but requiring income yield to
meet a fund’s charter can achieve both aims through convertibles. US equity
income funds, in particular, are currently big users of convertibles.

7. Deutsche Morgan Grenfell Convertible Screenings

Deutsche Bank screens Using our extensive database of global convertible bonds, Deutsche Morgan
the convertible markets Grenfell Convertible Research produces regular analysis of the world's markets.
for equity opportunities Everyday we produce screenings of the convertible universe for equity trading
daily opportunities.

One of the screenings that appears daily on our

www.db.com/cb

website is a screening of each of the world's markets for equity investors. An

example of the current position in the European market, where we selected
convertibles with a premium of less than 10%, is shown in Table 7.

This table demonstrates a few of the analysis tools we have described above.

Clients requiring access to our website should contact their Deutsche Bank
Convertible sales representative.

Convertibles 7
Table 7: Equity Switch Opportunities in Europe

Issuer Coupon Maturity Ask Parity Prem YTM Stock Flat Break Stock Bond Bond Stock Bond Bond
(%) (%) (%) Yield Yield even up 25% With Upside Down With Downside
(%) (%) (yrs) Stock 25% Stock
Up Down
BAA (Old) 5.75 Mar-06 131.5 120.4 9.2 1.5 2.4 4.4 4.4 27% 24% 89% -23% -15% 68%
Banca Intesa-ORD 5.81 Jan-03 316.0 293.6 7.6 -20.6 0.5 1.8 5.4 26% 24% 95% -24% -23% 96%
Banca Intesa-RISP 6.30 Jan-03 259.0 249.9 3.7 -16.0 0.5 2.4 1.8 26% 26% 101% -24% -23% 92%
Canal Plus/Media 3.50 Feb-02 138.5 134.8 2.8 -5.5 2.0 2.5 4.8 27% 27% 100% -23% -15% 64%
Compass 5.75 Oct-07 162.3 148.3 9.4 -0.7 1.0 3.5 3.3 26% 25% 95% -24% -18% 77%
Cregem/ING $ 2.75 Jan-04 132.5 127.4 4.0 -2.6 1.7 2.1 9.3 27% 24% 89% -23% -18% 76%
Greenalls 7.00 Sep-03 125.0 112.9 10.7 2.0 4.0 5.6 6.1 29% 24% 84% -21% -11% 52%
Hammerson 6.50 Jun-06 131.0 122.3 7.1 2.2 2.8 5.0 3.1 28% 26% 92% -22% -16% 70%
Holderbank 0.00 Jun-11 110.0 110.1 -0.1 -0.7 1.0 0.0 0.1 26% 26% 101% -24% -24% 99%
Land Securities 7.00 Sep-08 156.0 154.0 1.3 1.2 3.6 4.5 1.4 29% 27% 94% -21% -21% 99%
Medio/Banca Roma 3.50 Jan-01 219.3 218.1 0.5 -24.3 0.0 1.6 0.3 25% 26% 104% -25% -23% 92%
Nestle 3.00 Jun-02 143.0 136.9 4.5 -6.1 1.1 2.1 4.2 26% 24% 92% -24% -22% 94%
P&O 7.25 May-03 130.0 126.3 2.9 1.0 4.4 5.6 2.4 29% 32% 108% -21% -9% 45%
Royal Bam 4.75 Dec-04 121.0 113.4 6.7 1.4 2.9 3.9 5.8 28% 25% 90% -22% -11% 50%
Sandoz US$ 2.00 Oct-02 162.5 159.3 2.0 -9.4 1.0 1.2 7.9 26% 26% 100% -24% -21% 89%
United News 6.13 Dec-03 126.0 114.0 10.6 1.2 2.6 4.9 4.2 28% 20% 72% -22% -14% 61%
Volkswagen $ 3.00 Jan-02 167.0 166.8 0.1 -11.4 1.1 1.8 0.2 26% 25% 97% -24% -24% 100%
Source: Deutsche Morgan Grenfell Estimates
Deutsche Morgan Grenfell Global Convertibles

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