Convertible bonds gain traction in Asia

Convertible bond (CB) prices had fallen to such a degree by March last year that Asian issues were extremely attractive, and investors -- particularly in Europe -- bought in heavily. That has sparked interest in a market that only kicked off in the region in 2006, says Natalia Barazal, Geneva-based convertible bond manager at Swiss asset manager Lombard Odier.

The firm set up an Asian CB fund in December 2008, which was up 24.2% as of December 31. And since many Asian corporates will need to refinance in 2010 and 2011 -- either by spreading out their debt, through CBs or other methods -- the Asian CB market is likely to remain buoyant, she tells AsianInvestor during a recent trip to Hong Kong.

Interest in CBs has been acute in the last six to nine months of 2009, says Barazal. "What happened last year attracted the interest of many investors," she says. "Many were looking at credit after getting out of equity, and convertible bonds are credit-related, hybrid instruments."

Barazal says that during the crisis, CB values crashed disproportionately, to the extent that they ended up trading below the value of the bond component. Buying at that price gives investors a free call option, she adds, and a higher yield on the convertible bond than straight debt.

"Most of the options were so out-of-the-money last year that you'd imagine they were worthless, and anyway you could buy CBs cheaper than the straight debt, with higher yield," she says. "Valuations were below anything we'd ever seen. How else could you buy CBs and get twice the return of the straight debt?"

She concedes that there was a certain discount for the assets' illiquidity -- maybe 1 or 2 percentage points -- but hardly anything compared to the potential return.

Barazal cites Newscorp, a US issuer, which was rated BBB+ with a put next year. After the first sell-off, straight debt was yielding 6-7% after two to three years, but the Newscorp CB after two years was close to 10%, and yet it still offered an equity option.

In general, straight debt was yielding around 6% or 7% from October onwards and CBs have been showing close to 15% yields since then. "CB sellers such as hedge funds had to de-leverage big time in October, so were panic selling," she says. "They were basically saying give me a price and I'll sell.

"[As a result of these factors,] you absolutely needed to look at CBs last year," says Barazal. Lombard Odier currently has around 5% of its clients' portfolios, globally, invested in these instruments.

And Asia is growing in prominence; the region now represents 12.3% of the MSCI and accounted for 13% of new CB issues last year. The US used to be the main driver of new issues, she says, but that mantle has now shifted to Europe, with Asia growing very fast.

However, Barazal concedes that if interest rates were to rise and equity markets to crash -- a situation not beyond the realms of possibility in 2010 -- that would be "the worst-case scenario". "In that case, nothing would be holding up CBs," she says.

"But compare CBs in that scenario to cash or credit," says Barazal. "Certainly, rising interest rates are negative for credit, but you're still making more than on cash on the CB credit component, because you have a pick-up due to spreads widening."

CBs are attractive in good equity markets or good credit markets when rates are low or falling, she continues. Yet even if rates are rising, they may be a good investment, she argues. If a recovery is under way and central banks are simply raising rates to keep them at adequate levels, while equity markets are doing well, CBs will also prosper.

Barazal is not alone in her belief that the CB market in Asia, and elsewhere, is set to boom. For example, Paris-based Edmond de Rothschild Asset Management is considering setting up an emerging-market CB fund, taking the view that conditions will continue to favour such issues. And back in mid-2009 hedge fund Triskele Capital launched a CB fund.

*A CB is a bond that can be converted into a predetermined amount of the company's equity at certain times during its life through a stock option embedded in the contract.