Tuesday, November 11, 2008

Are Convertible Bonds a "Screaming Buy"?

Investment grade corporate bonds have "outperformed" high yield bonds, which have "outperformed" convertible bonds, which have "outperformed" the S&P 500. Why the "quotes"? Because the best performing of the bunch is still down more than 10% YTD.

While it is hard to look at the above chart and not see at least some value, convertible bonds are what catches my eye as they have performed like equities, even though they are (per the WSJ):

part stocks, part bonds. They act like bonds and usually pay interest. But, as an added kicker, they give holders the right to convert the securities into stocks at a certain price. The market is normally less volatile than stocks, but the securities can have the same upside if a company rebounds.
The massive hedge fund unwind has sent convertible bonds reeling. Back to the WSJ:

Hedge funds, which at times owned as much as 70% of the outstanding convertible bonds, traditionally try to protect themselves by shorting, or borrowing and selling, shares of the same companies, profiting from the difference in the movement of the securities. But some funds did a poor job hedging themselves, or didn't do much hedging at all, figuring the market wouldn't tumble, traders say.

At the same time, some funds focused on convertibles borrowed as much as $5 for each $1 of equity in recent years, leverage that for some has turned small losses into huge ones. A 10% loss can become a 60% drop if a firm's borrowings amounted to five times its capital.

In other words, technical rather than fundamental factors are at play qualifying these for the latest installment of screaming buy. Does anyone know of a good convertible bond fund?

Source: Barclays

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