Bill Feingold Convert Presentation

Convertibles: History, Half-Truths and Opportunities Bill Feingold March 2, 2006

“ That's why the convertibles are so intriguing: It's a security that straddles the divide between the risk-return pricing model and the what-the-hell pricing model.” -H.W. Jenkins, Jr. “ And so we'll argue and we'll compromise And realize that nothing's ever changed For all our mutual experience Our separate conclusions are the same Now we are forced to recognize our inhumanity Our reason co-exists with our insanity So we choose between reality and madness It's either sadness or euphoria” -Billy Joel

WHY ARE WE HERE?
Not an existential question, even at the Yale Club!
Gain a better understanding of an asset class that
Best aligns management and investors
Can legitimately be argued as the “core building block” of finance
Hopefully a lot more fun than Google analyst day!
Google would be the dream convertible issuer
Great company
Equity a mystery – valuation could be anywhere
This leads to recall of H.W. Jenkins Jr. line, “What makes convertibles so intriguing…”
But…all these points suggest why properly priced convertibles may dominate equities or bonds
Significantly better risk/reward profile  higher expected returns
Higher in capital structure
New set of opportunities for traditional equity/fixed-income buyers

WHY ARE WE HERE?
Idea of “everything arbed out” transparently ridiculous: function of each situation
Not all half-truths have negative spin
“ I know what you guys do”: misunderstanding of nature of exposure
Statistical volatility often grossly overstated, leading to overvaluation
Fallacy of decomposition with incomplete markets: not so easily hedged
My objectives
I love to teach!
Help broaden understanding and investor base

THE 5 W’S OF CONVERTS FOR DUMMIES
WHAT
Fixed-income securities that can be turned into stock at the holder’s option at, essentially, a pre-specified price
Primarily bonds, but some preferred stocks
Please note: DON’T CONVERT RIGHT AWAY WHEN THE STOCK GOES ABOVE THE CONVERSION PRICE!!
(Don’t throw away the option value!!)
If you want out, sell to somebody who values the security properly!
A small part of the market requires conversion into common stock at maturity

WHAT (continued)
Trade at some premium to parity (value if immediately converted into stock)
Premium is a function of many factors
Income advantage over common stock
Volatility of stock
Credit quality of issuer
Issue-specific factors
“ Low-premium” convertibles: highly stock-sensitive with relatively little downside protection
Volatility almost always is a good thing
“ High-premium” (i.e. “busted”) convertibles: highly credit-sensitive, share in less of stock upside/downside
Volatility is not necessarily good (at all!) for these
Distressed convertibles (bottom of food chain) are once again highly sensitive to stock price

WHO/WHY
Investors (hopefully to include some of you before long)
Mildly frustrated stock jockeys
Total-return yield buyers
Growth/income buyers
Arbs (funded largely by funds of funds)
Pricing function is absolutely critical
Contrary to some belief, they dampen market volatility
“ Lenders of last resort”
Issuers
High-growth companies
Profitable cash consumers
Biotech (I love biotech—perversely good credit)
Fallen angels needing capital fast for survival
Tax/EPS game-players

WHERE
Primarily an over-the-counter and relationship-based market
Execution thus has meaningful impact on performance (mostly for arbs)
Some convertible preferred issues trade on floor but real trades are still handled over-the-counter
Although fixed-income securities, convertibles are traded on the equity floors of major Wall Street dealers…
… thus much of the opportunity!

HOW (valuation)
Old-fashioned approach simply looks at income advantage vs. stock
Binomial approach goes to ultimate outcome at maturity and works backwards
Conceptually can think of two ways:
Bond plus call (easier for fixed-income buyers)
Stock plus put (easier for equity buyers)
Both techniques have limitations because of lack of separability
Credit derivatives market partly…only partly…helps
See “How Opportunities Arise”

HISTORY OF A MISUNDERSTOOD SECURITY
19TH CENTURY INTERNET: THE RAILROADS
Vanderbilt Avenue salutes Commodore Cornelius Vanderbilt…
Erie RR: Triumvirate of Drew, Fisk & Gould vs. the Commodore
One of first investors to get burned by not understanding convertibles!
Poorly informed attempt at cornering stock of Erie
Drew kept shorting stock, Vanderbilt and most others thought Drew was making a losing bet
Had actually bought stock via convert at a huge discount to the market price
Not that different from questions I often get from brokers these days!

LATE 20 TH CENTURY INTERNET: THE ARBS MOVE IN
Private secret of partners at WS firms pre-1980’s
Simple buy convert, short stock, extremely low premium/risk
Risks of dividend, takeover, borrow but minimal credit/volatility risk
“ Breakeven theory” becomes more widespread in 1980’s
Pay 12 points over conversion value, collect 15 points in coupons, “lock up” three pts.
Still is easiest way to explain…thus still considered valuation benchmark
Ignores many important things including financing and credit
Compelling “swap” for stock buyers
First structural improvements
Poison puts (takeover protection for beaten-up stocks)
General elimination of “screw clauses” (lose last coupon via sneaky language)
More sophisticated “arbitrage” in 90’s…based on option theory
Generally high volatility despite overall strong equity markets
1994, parts of 1997-8 bad patches in very good period

A NEW MILLENIUM: IF IT WORKS, FOLLOW, FOLLOW, FOLLOW…UH-OH
Great performance in early 2000’s on back of high volatility, falling rates, issuance of converts with stocks at bubble prices
Jenkins: risk/reward vs. “what-the-heck”
Good company with bad stock
“ Bad:” possibly EXTREMELY overvalued with no negative credit implications
The “Holy Grail” of convertible arbitrage
Over 20-year period, US converts essentially provided:
Same total returns as stocks
Half the volatility
Performance-chasing by funds-of-funds 2002-3
Issuance to meet demand as always (largely by better credits, less “vig”, “all arbed out,” league-table loss leaders)
The saga of Mandalay Bay
2003: Dividend (you messed up, you trusted us)
2004: Cash takeover (leads to protection for winning stocks)

2005: AN “in your face” ODYSSEY

Followed upon two years of flattish performance, down in many cases
Those two years coincided with turnaround in stock markets
From perspective of hedged portfolio (stocks, bonds, commodities, real estate, convertibles, timber, etc.), should not have been that surprising
But … as so often happens… was viewed in a vacuum…flip side of several years earlier
Rumors of mass redemptions in 2004 did not jibe with performance, but in early 2005…

Some funds of funds managed based on valuation; most did based on what they heard others were doing…despite
Major structural improvements (thanks largely to Mandalay Bay)
Powerful mean-reverting properties based on return of capital
“ Other than price, what has changed?”
Yes, a senior “investment professional” did ask me that…
Asset class…particularly in arbitrage sense…not dependent on “greater fool” theory
“ I’ll get back in when it’s become more fashionable”
“ Our reason coexists with our insanity”
Funds flows
Out of relative-value/market neutral (convertible arb, fixed-income arb)
Into more active selection process (long/short equity, global macro)
Following volatility lower and lower
VIX partially overrated, nonetheless lowest in 15 years
Similar for fixed-income volatility

Convertible arbitrage “Most hated nation” by 87% of funds-of-funds polled in April 2005
Incentives of most asset allocators: more to lose on downside than gain on upside
Meetings supposedly for in-depth trade discussion became “when does selling stop?”
Spring 2005: anecdotally worst time since 1970’s (or earlier!) for convertibles
Locking in big losses for investors
Redeem from convertible-arbitrage fund with large drawdown
Pay bigger transaction costs (dealer spreads) that come with unhealthy markets
End up owning same securities by transferring redeemed funds into multi-strategy funds that purchase the convertibles, but…without old watermark!
“ In the tidal destruction, the moral melee…” (thanks, Ian/Jethro)

Selling dries up mid-May after redemption deadline, kicks in late-September through mid-Nov
Bottom line: Tremendous opportunity for investors with longer horizons!
While a significant portion of the opportunity has been recaptured already, a meaningful part is still there
Key: Value in keeping abreast of market tone
Relationships and proper horizon  winning results

HALF-TRUTHS
How easy to hedge…and thus, is it as truly a derivative?
As time horizon expands, broad-scale hedging starts to make more sense
Do extra layers of hedges do more harm than good if capital is fleeting and transaction costs are high (spreads not commissions)?
Smaller issues intrinsically more difficult to hedge
Markets far less “complete” than outsiders think
Volatility and credit…all you know, all you need to know? NOT
Busted converts = short volatility (no news is good news)
How does the interplay work? When can you separate, when can’t you?
Equity and debt as building blocks vs. converts
Ability to allocate returns
“ Standstill” for arbs actually involves trading to offset time decay
Yet, “gamma trading” (i.e. constant re-hedging) is overrated
Embedded options are long-lived
See my basketball/options treatise

HOW OPPORTUNITIES ARISE
NEW ISSUES
Opportunity when the company really wants, but doesn’t absolutely positively need, the money
Company needs to sell at discount to “fair value” to raise big block of capital
Issue after stock has had good run
Attractive to arbs
Arb-selling pressure helps new buyers get in
New investor base puts less pressure on stock (Jenkins)
CHANGED PROFILES
When in doubt, go with the profile and forget the model
“ Sweet spot” trading between 80-95% of par
Supply/demand imbalance greatest in this range
Overnight “gap” moves in stock vs. “dollar-neutral” trading
How theory gets put into practice
Importance of fair, reputable dealing in fast markets

HOW OPPORTUNITIES ARISE
HORIZON CONFUSION
Assets with 3-5 year life on average
Extremely FINITE supply/demand per issue
Expected to have day-to-day and month-to-month mark-to-market behavior of two-month options where infinite supply can be created
“ Crunch all you want, we’ll make more” with options; hedge one month/strike with another
Converts—each has its own personality
“ We don’t feel like adding another line to our spreadsheet” (top holder of more expensive convert)

WHERE TO NOW?
Arbitrage renaissance this year, but…
Unquestionably better suited to more flexible, longer-term pools of capital
Capitalize on myopic trading
General ways of taking advantage of the asset class for unhedged investors
Enter investment below par (or maintain exposure) after stock decline
Swap from stock into convertible after stock gain
Intel issuance highly encouraging
One man’s opinion:
2005 a bad blip on the way to long-term development of the asset class
But, will be long process
For further information:
Bill Feingold
[email_address]
917-602-1908
http://trueconverts.blogspot.com
All opinions are entirely my own and…
Do not represent any organizations I have been, or will be, affiliated with

About the Speaker
Since earning his MBA with distinction from Wharton in 1991, Bill Feingold has spent his entire career trading and researching convertible bonds and other derivative instruments. His work experience includes senior roles on both the buy and sell sides; past firms include FrontPoint Partners, Clinton Group, Lehman Brothers, First Boston and PaineWebber. Bill has been a frequent speaker at industry conferences and his intuitive writings on convertibles and options have been published in several anthologies. Bill is a Phi Beta Kappa graduate of Yale, where he has taught and lectured, and his career has included stints as a semi-professional horseplayer.

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Bill Feingold Convert Presentation

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