Converts Trading
Hi all,
Looking to gain some insight into converts trading. Interested what it’s like on the sell side (buy side insights welcomed too), day-to-day etc.
My assumption is that the less-liquid nature of converts calls for some credit/equity analysis component even if you are simply making markets (as opposed to buy and hold). This could be completely wrong.
Some things I’d be interested in knowing:
-Does the sell side (are they allowed) to hold converts positions on their book, the way you would be able to with say, distressed credit in a more proprietary nature ?
-Convertible Bond Arbitrage. Is it a form of capital structure arbitrage? I understand how the trade works mechanically but am confused how it works in practice. Maybe if someone had an example that would be great. Basically I am interested in the valuation component. I know that the value of a convert theoretically is sum of the value of the embedded option and the bond but I guess I am wondering, in the arbitrage scenario, how are you arriving at the conclusion that the convert is cheap and the equity is overvalued? Are you calculating an enterprise value via a DCF that deems the convert to be undervalued at current market prices and the equity to be overpriced and assuming the value will converge?
- Any other experiences on a converts desk welcomed.
Sorry for the loaded post, it’s an interesting product I’ve been trying to understand further.
Thanks
Hi Analyst 1 in ER, just trying to help:
More suggestions...
Hope that helps.
bump
Hey man... Work on a sell-side converts desk...
To start, there is a lot of buying and holding inventory on our desk. Some of that is a product of our view but also you have to trade the flow of the market. Some converts trade way more than others so you want to have an inventory when a customer wants to get involved. Most of our positions are held on a delta though for risk purposes not many outright positions.
The 2 most important parts when valuing a convert are the credit and vol assumptions. That's where you find theoretical fair value and convert arb consists of at it's most basic form buying when it's cheap to fair value. For ex. if your Credit Sp assumption is implying a vol of 34 when listed options are implying you can realize a vol of 40 on that name it is trading cheap and you would go long the convert and short the stock and realize that gain as the vol richens. We use a converts model, but rarely ever value the equity itself.
Day-to-day on the desk you just try to keep up with flows and finding and negotiating between the buyers and seller to find a price where you can risklessly cross easier and make the spread. With some illiquid bonds it's more a matter of relationships and knowing who holds what bond so you can always find the other side of a trade. Also watching TRACE to keep up whether bonds are getting richer or cheaper and adjusting your markets to not get picked off by a HF that sees you off on a handle.
PM me if you want to know anything more specific
I can talk a lot about this. But need to be on a keyboard. PM me.
The US CB market issuance wise is huge and growing but the number of participants especially on the HF side has shrunk dramatically in the last decade. It’s not an optimistic place to be. Sell side desks have gotten crushed and downsized. Ex US issuance is down coupons are near zero companies can issue at well above implieds meaning there is no arb and negative carry. Ugh.
Most guys in the market are traders and do very little actual company research or care to. They are used to positive carry vol trading which is less and less possible. And so are trying to hang onto seats or have left. I think it’s actually a great product.
Once again feel free to PM.
Cheers
OK OP - I am sitting at a keyboard right now and will try to keep this basic, but will probably fail to do so. Apologies in advance.
First of all, who issues Converts? 2 kinds of companies. 1. Fast growing, smaller, tech/healthcare that can't or doesn't want to pay high rates of interest or can't access straight loan/bond markets, AND doesn't want to dilute by issuing equity. 2. Companies that will just have to pay too much interest or really need a re-fi and are trying to put off financial stress. 3. It can be a combination of both.
What elements do Converts ("CBs") have? they give the investor access to credit, equity and volatility. The bond in CB is credit, and the convertibility comes from the embedded call option which gives stock and vol exposure.
How do companies benefit? They get to borrow and it goes on their balance sheet as debt. But interest rates are lower, so less cash outflow that can be used for growth etc. The attached option which gives the CB it's convertibility usually has a strike price well above the current strike price. By the time investors want to convert, the stock price has usually gone up so much that existing shareholders won't care about dilution as much.
How to get investors? Well, the company says in exchange for you taking these risks, and paying you a lower coupon, you get stock like upside if things go well. In a number of cases if the company goes belly up, the CB may be pretty senior in the capital structure. It may be the only debt in the capital structure.
Who are the investors? Well there are mutual funds that don't lever up and don't short or really hedge. They are usually more fundamentals based. Typically they will do equity and credit work (often pretty cursory frankly), figure out that the company won't go under, and so figure you have the security of a bond with the upside of a stock. They don't really pay attention to the optionality (vol) part of the product. They also track convertible indices and so are limited to what kind of bonds they can buy by size, industry, tenor, how far in or out of the money etc. Mutual funds are like 60-70% of the market today globally.
Then there are hedge funds. Hedge funds used to be 60%-70% of the market but since converts BLEW UP in the crisis and in some cases did worse than holding equity (this is like exactly the opposite of what is supposed to happen in relative value trading strategies), a lot have closed or are struggling. Hedge funds may do some fundamental work, but really they are really just looking to isolate one or a few variables that CBs give access to. It's much more technical, product knowledge, trying to find gaps and lever into that, rather than "is this company good/bad?" Most are interested in vol.
Remember when I talked about companies that issue convertibles? It used to be that hedge funds dominated the CB market and so companies would negotiate with banks (who negotiate with funds) on terms of the CB. Hedge Funds would pretty much be like "this is a speculative growth company and I'm not sure about the credit. I see the stock has a realized vol of like 60, so why don't you issue the CB at like 30 vol and we will bite" (this is a highly simplified example but that's the genesis of it). So hedge funds would buy the CB and then short stock against the option (or to be even more cute, short the company's listed or OTC call options) against it to lock in that profit. Literally buy low (CB vol at 30) and sell high (listed/OTC option at 60).
Now remember that these CBs pay interest. Now also remember that when you short stock that you get cash from that short that is deposited in your bank account (net of borrow costs one get a positive stock rebate). So the clever hedge fund comes in and clips a coupon, clips some interest from the short stock rebate and just re-hedges the delta exposure every day. Now because the option is valued at such a discount (ie. valued as if the stock moves upto 60% a year in either direction or anywhere in between that - standard bell curve) but the option on the CB is valued as if that number is 30%, one can make a lot of money trading around that. So you are being paid interest to hold this cheap cheap option in which you can trade around a stock's volatility. You also use less capital because you have a bond, but you also have cash from the short stock to count against it. Since you are hedged, your trade seems less risky so your friendly prime broker will lend you more money to size up the trade. So you can level up and make lower risk, high return trades. Of course in this example you are long credit and vol and delta neutral. Plenty of hedge funds also hedge the credit (via CDS or treasury futures - though neither is easy or perfect).
Sounds great! So why is the market so bad? Well, in general, rates are super low and there is money everywhere. So companies can access the straight bond market. Or they can pay next to no coupon. That means investors don't get to clip a coupon. Markets have generally gone straight up. That means there is little to no vol. There isn't much to trade around when markets just grind up, and in options markets there are tons of vol sellers, which means hedged you get crushed on vol scrunch as well). Oh and since rates are low, you don't get much of a short rebate either.
Now the International Markets, rates are literally zero. Companies borrow at 0% rates. Investors still have to pay 50bps to borrow stock to short. But since rates are zero the investor (HF) also gets negative interest rates on the short deposit. So the HF is PAYING to hold this option. Oh and since markets are hot and there is no vol and mutual funds are now dominant and don't look at vol, companies can not only issue at 0% coupon, but can also value their imbedded option well above the stock volatility. Does a company's stock annualize 30% volatility. Well they can go and issue a CB at 0% interest and like 50% vol since the mutual funds will buy it. And so they do. So if you hedge that equity delta out, and try to trade around the volatility with that, and are paying to do so (negative carry) it's a guaranteed way to lose money.
I hope this helps.
Good Luck
Sheesh - thanks for taking the time to type this out.
I did not get to finish my post and for some reason was not able to properly edit it.
Capital structure arbitrage is a fun way of saying long one asset, short another similar one. So someone could see that the CB's yield is trading similar to straight bonds, but it has this embedded option. So long the CB, short the straight bond since if all is well, the equity returns from the option component should juice that trade.
Another way is shorting stock against the CB. You are long credit, but short stock. Different parts of the capital structure right?
How to come up with a conclusion if something is over or underpriced? For the CB, look at comparable bonds of the company or competitors. Are they trading wider? Or tighter? With some very simple financial projections (if that) you can be like hmmm this is 300 wide but it's straight bonds at 350 wide. This is cheap credit.
Or you can look at the stock's volatility and listed options of a similar maturity (often not around so need to price OTC)... Is there a difference there? Or is the stock realizing a lot of vol recently? Will there be a lot of vol int he future due to a product release or trade war or whatever?
Or maybe you are bullish the stock due to some technical or fundamental reason? So you buy the bond and hold it outright (like a mutual fund) except you are levered. If the credit doesn't blow up, your losses are limited but you get much of the equity upside potential.
Most of these guys are not gifted or detailed analysts. They are traders first and foremost. As a CB person you get to learn a lot of asset classes and learn how everything moves. There are a lot of ways to make (and lose!) money.
That's the gist of it.
Good Luck
PS on hedging out (in my previous post).... if you have a stock that moves a lot, and say is realizing 60 vol, but are holding an option that values the movement of that stock at 30 how do you make money? Essentially you buy the 30 vol option (the CB) and then hedge your stock delta but shorting stock. Now your 30 vol option might be worth, let's say $10 bucks, and a 60 vol option may be worth $20. As you sell stock (if stock goes higher, the option's sensitivity to equity movements goes higher as it gets closer to being in the money, thus you need to sell more stock to hedge out stock risk) and buy stock (as it goes lower the option's sensitivity to equity movements lowers as it goes more and more out of the money), you are literally buying stock low and selling it high.
The embedded CB option is priced such that the stock only moves x amount, even though in reality the stock moved 2x amount. This means your are trading around the stock a lot more and are effectively writing off the value of the option as you make profit from trading around the stock. The exact opposite happens if you own an expensive option which is the current state of the market, especially ex-US.
I hope this isn't too confusing. I can explain in person but tougher on this keyboard.
Great comment. In response to OP's first question, I would add that sell-side desks in general have become incredibly commoditized -- even in (relatively) niche markets such as converts. So yes, while desks do hold inventory, balance sheets and position sizes are miniscule compared to pre-crisis. And sure, you can look at credit and vol assumptions and (to an extent) express views on if a bond is rich/cheap, but as @Jamoldo mentioned, at the end of the day your focus on the sell-side going to be market-making and trading, not in-depth fundamental research.
Additionally, you have asymmetric risk and information on the sell-side. While you might have an edge from a technical standpoint (i.e. recent flows, who's buying/selling), you might be making markets on 100 names while a hedge fund might have a whole team of analysts focused on just 10. You're crossing bonds, trying to generate flows, and you might make two points on a good trade but lose ten on a bad one. On the sell-side, you have to trade, whereas the buy-side guy can sit and wait to pick you off.
Lastly, given issue sizes and current market dynamics, liquidity is still a issue, especially because, as @Jamoldo mentioned, real money drives most of the flows in the market nowadays. Moreover, with MIFID, the large European asset managers have to trade in comp, further decreasing spread for dealers (again, commoditization of the sell-side).
That being said, converts are a fascinating product. You get a ton of exposure to different asset classes, looking at anything from traditional vol/convert arb opportunities to super distressed situations. Just wish the market weren't garbage.
Hi Jamoldo, your insights on converts are impressive. Could you please share your views on the current market environment? I have an opportunity to move to CB / cap structure arbs at a large HF. Would really appreciate your perspective. Thank you.
Want to bump this to get a glimpse at the converts market since volatility has picked up. Seems like issuance in the space has risen dramatically as equity markets fell off a cliff in March. Several of the companies hit hardest by the pandemic are using converts to get access to cash quickly and look to "equity upside" as justification for low rates.
I'm curious to see how this has been from a secondary market/trading perspective perspective over the past few months. @jamoldo maybe you could comment as you had valuable insights above.
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