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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...
WHY ARE WE HERE?   <ul><li>Not an existential question, even at the Yale Club! </li></ul><ul><li>Gain a better understandi...
WHY ARE WE HERE?   <ul><li>Idea of “everything arbed out” transparently ridiculous:  function of each situation </li></ul>...
THE 5 W’S OF CONVERTS FOR DUMMIES  <ul><li>WHAT </li></ul><ul><ul><li>Fixed-income securities that can be turned into stoc...
THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>WHAT (continued) </li></ul><ul><ul><li>Trade at some premium to parity (value if...
THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>WHO/WHY </li></ul><ul><ul><li>Investors  (hopefully to include some of you befor...
THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>WHERE </li></ul><ul><ul><li>Primarily an over-the-counter and relationship-based...
THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>HOW (valuation) </li></ul><ul><ul><li>Old-fashioned approach simply looks at inc...
HISTORY OF A MISUNDERSTOOD   SECURITY <ul><li>19TH CENTURY INTERNET:  THE RAILROADS </li></ul><ul><li>Vanderbilt Avenue sa...
HISTORY OF A MISUNDERSTOOD SECURITY <ul><li>LATE 20 TH  CENTURY INTERNET: THE ARBS MOVE IN </li></ul><ul><li>Private secre...
HISTORY OF A MISUNDERSTOOD SECURITY <ul><li>A NEW MILLENIUM:  IF IT WORKS, FOLLOW, FOLLOW, FOLLOW…UH-OH </li></ul><ul><li>...
2005:  AN “in your face” ODYSSEY
2005:  AN “in your face” ODYSSEY <ul><li>Followed upon two years of flattish performance, down in many cases </li></ul><ul...
2005:  AN “in your face” ODYSSEY <ul><li>Some funds of funds managed based on valuation; most did based on what they heard...
2005:  AN “in your face” ODYSSEY <ul><li>Convertible arbitrage “Most hated nation” by 87% of funds-of-funds polled in Apri...
2005:  AN “in your face” ODYSSEY <ul><li>Selling dries up mid-May after redemption deadline, kicks in late-September throu...
HALF-TRUTHS  <ul><li>How easy to hedge…and thus, is it as truly a derivative? </li></ul><ul><ul><li>As time horizon expand...
HOW OPPORTUNITIES ARISE  <ul><li>NEW ISSUES </li></ul><ul><ul><li>Opportunity when the company really wants, but doesn’t a...
HOW OPPORTUNITIES ARISE <ul><li>HORIZON CONFUSION  </li></ul><ul><ul><li>Assets  with 3-5 year life on average </li></ul><...
WHERE TO NOW?  <ul><li>Arbitrage renaissance this year, but… </li></ul><ul><li>Unquestionably better suited to more flexib...
About the Speaker <ul><li>Since earning his MBA with distinction from Wharton in 1991, Bill Feingold has spent his entire ...
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Bill Feingold Convert Presentation

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Presentation on Convertible Bonds, The Yale Club, New York City, March 2, 2006

  • Excellent explanations of convertible bond market and its performance in various economic cycles. Market history, convert structures, opportunity for future investors.

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Bill Feingold Convert Presentation

  1. 1. Convertibles: History, Half-Truths and Opportunities Bill Feingold March 2, 2006
  2. 2. “ 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
  3. 3. WHY ARE WE HERE? <ul><li>Not an existential question, even at the Yale Club! </li></ul><ul><li>Gain a better understanding of an asset class that </li></ul><ul><ul><li>Best aligns management and investors </li></ul></ul><ul><ul><li>Can legitimately be argued as the “core building block” of finance </li></ul></ul><ul><li>Hopefully a lot more fun than Google analyst day! </li></ul><ul><ul><li>Google would be the dream convertible issuer </li></ul></ul><ul><ul><ul><li>Great company </li></ul></ul></ul><ul><ul><ul><li>Equity a mystery – valuation could be anywhere </li></ul></ul></ul><ul><li>This leads to recall of H.W. Jenkins Jr. line, “What makes convertibles so intriguing…” </li></ul><ul><li>But…all these points suggest why properly priced convertibles may dominate equities or bonds </li></ul><ul><ul><li>Significantly better risk/reward profile  higher expected returns </li></ul></ul><ul><ul><li>Higher in capital structure </li></ul></ul><ul><ul><li>New set of opportunities for traditional equity/fixed-income buyers </li></ul></ul>
  4. 4. WHY ARE WE HERE? <ul><li>Idea of “everything arbed out” transparently ridiculous: function of each situation </li></ul><ul><li>Not all half-truths have negative spin </li></ul><ul><ul><li>“ I know what you guys do”: misunderstanding of nature of exposure </li></ul></ul><ul><ul><li>Statistical volatility often grossly overstated, leading to overvaluation </li></ul></ul><ul><ul><li>Fallacy of decomposition with incomplete markets: not so easily hedged </li></ul></ul><ul><li>My objectives </li></ul><ul><ul><li>I love to teach! </li></ul></ul><ul><ul><li>Help broaden understanding and investor base </li></ul></ul>
  5. 5. THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>WHAT </li></ul><ul><ul><li>Fixed-income securities that can be turned into stock at the holder’s option at, essentially, a pre-specified price </li></ul></ul><ul><ul><ul><li>Primarily bonds, but some preferred stocks </li></ul></ul></ul><ul><ul><ul><li>Please note: DON’T CONVERT RIGHT AWAY WHEN THE STOCK GOES ABOVE THE CONVERSION PRICE!! </li></ul></ul></ul><ul><ul><ul><li>(Don’t throw away the option value!!) </li></ul></ul></ul><ul><ul><ul><li>If you want out, sell to somebody who values the security properly! </li></ul></ul></ul><ul><ul><li>A small part of the market requires conversion into common stock at maturity </li></ul></ul>
  6. 6. THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>WHAT (continued) </li></ul><ul><ul><li>Trade at some premium to parity (value if immediately converted into stock) </li></ul></ul><ul><ul><ul><li>Premium is a function of many factors </li></ul></ul></ul><ul><ul><ul><ul><li>Income advantage over common stock </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Volatility of stock </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Credit quality of issuer </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Issue-specific factors </li></ul></ul></ul></ul><ul><ul><ul><li>“ Low-premium” convertibles: highly stock-sensitive with relatively little downside protection </li></ul></ul></ul><ul><ul><ul><ul><li>Volatility almost always is a good thing </li></ul></ul></ul></ul><ul><ul><ul><li>“ High-premium” (i.e. “busted”) convertibles: highly credit-sensitive, share in less of stock upside/downside </li></ul></ul></ul><ul><ul><ul><ul><li>Volatility is not necessarily good (at all!) for these </li></ul></ul></ul></ul><ul><ul><ul><li>Distressed convertibles (bottom of food chain) are once again highly sensitive to stock price </li></ul></ul></ul>
  7. 7. THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>WHO/WHY </li></ul><ul><ul><li>Investors (hopefully to include some of you before long) </li></ul></ul><ul><ul><ul><li>Mildly frustrated stock jockeys </li></ul></ul></ul><ul><ul><ul><li>Total-return yield buyers </li></ul></ul></ul><ul><ul><ul><li>Growth/income buyers </li></ul></ul></ul><ul><ul><ul><li>Arbs (funded largely by funds of funds) </li></ul></ul></ul><ul><ul><ul><ul><li>Pricing function is absolutely critical </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Contrary to some belief, they dampen market volatility </li></ul></ul></ul></ul><ul><ul><ul><li>“ Lenders of last resort” </li></ul></ul></ul><ul><ul><li>Issuers </li></ul></ul><ul><ul><ul><li>High-growth companies </li></ul></ul></ul><ul><ul><ul><ul><li>Profitable cash consumers </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Biotech (I love biotech—perversely good credit) </li></ul></ul></ul></ul><ul><ul><ul><li>Fallen angels needing capital fast for survival </li></ul></ul></ul><ul><ul><ul><li>Tax/EPS game-players </li></ul></ul></ul>
  8. 8. THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>WHERE </li></ul><ul><ul><li>Primarily an over-the-counter and relationship-based market </li></ul></ul><ul><ul><ul><li>Execution thus has meaningful impact on performance (mostly for arbs) </li></ul></ul></ul><ul><ul><ul><li>Some convertible preferred issues trade on floor but real trades are still handled over-the-counter </li></ul></ul></ul><ul><ul><li>Although fixed-income securities, convertibles are traded on the equity floors of major Wall Street dealers… </li></ul></ul><ul><ul><li>… thus much of the opportunity! </li></ul></ul>
  9. 9. THE 5 W’S OF CONVERTS FOR DUMMIES <ul><li>HOW (valuation) </li></ul><ul><ul><li>Old-fashioned approach simply looks at income advantage vs. stock </li></ul></ul><ul><ul><li>Binomial approach goes to ultimate outcome at maturity and works backwards </li></ul></ul><ul><ul><li>Conceptually can think of two ways: </li></ul></ul><ul><ul><ul><li>Bond plus call (easier for fixed-income buyers) </li></ul></ul></ul><ul><ul><ul><li>Stock plus put (easier for equity buyers) </li></ul></ul></ul><ul><ul><ul><li>Both techniques have limitations because of lack of separability </li></ul></ul></ul><ul><ul><ul><li>Credit derivatives market partly…only partly…helps </li></ul></ul></ul><ul><ul><li>See “How Opportunities Arise” </li></ul></ul>
  10. 10. HISTORY OF A MISUNDERSTOOD SECURITY <ul><li>19TH CENTURY INTERNET: THE RAILROADS </li></ul><ul><li>Vanderbilt Avenue salutes Commodore Cornelius Vanderbilt… </li></ul><ul><ul><li>Erie RR: Triumvirate of Drew, Fisk & Gould vs. the Commodore </li></ul></ul><ul><ul><li>One of first investors to get burned by not understanding convertibles! </li></ul></ul><ul><ul><li>Poorly informed attempt at cornering stock of Erie </li></ul></ul><ul><li>Drew kept shorting stock, Vanderbilt and most others thought Drew was making a losing bet </li></ul><ul><li>Had actually bought stock via convert at a huge discount to the market price </li></ul><ul><li>Not that different from questions I often get from brokers these days! </li></ul>
  11. 11. HISTORY OF A MISUNDERSTOOD SECURITY <ul><li>LATE 20 TH CENTURY INTERNET: THE ARBS MOVE IN </li></ul><ul><li>Private secret of partners at WS firms pre-1980’s </li></ul><ul><ul><li>Simple buy convert, short stock, extremely low premium/risk </li></ul></ul><ul><ul><li>Risks of dividend, takeover, borrow but minimal credit/volatility risk </li></ul></ul><ul><li>“ Breakeven theory” becomes more widespread in 1980’s </li></ul><ul><ul><li>Pay 12 points over conversion value, collect 15 points in coupons, “lock up” three pts. </li></ul></ul><ul><ul><li>Still is easiest way to explain…thus still considered valuation benchmark </li></ul></ul><ul><ul><li>Ignores many important things including financing and credit </li></ul></ul><ul><ul><li>Compelling “swap” for stock buyers </li></ul></ul><ul><li>First structural improvements </li></ul><ul><ul><li>Poison puts (takeover protection for beaten-up stocks) </li></ul></ul><ul><ul><li>General elimination of “screw clauses” (lose last coupon via sneaky language) </li></ul></ul><ul><li>More sophisticated “arbitrage” in 90’s…based on option theory </li></ul><ul><ul><li>Generally high volatility despite overall strong equity markets </li></ul></ul><ul><ul><li>1994, parts of 1997-8 bad patches in very good period </li></ul></ul>
  12. 12. HISTORY OF A MISUNDERSTOOD SECURITY <ul><li>A NEW MILLENIUM: IF IT WORKS, FOLLOW, FOLLOW, FOLLOW…UH-OH </li></ul><ul><li>Great performance in early 2000’s on back of high volatility, falling rates, issuance of converts with stocks at bubble prices </li></ul><ul><ul><li>Jenkins: risk/reward vs. “what-the-heck” </li></ul></ul><ul><ul><li>Good company with bad stock </li></ul></ul><ul><ul><ul><li>“ Bad:” possibly EXTREMELY overvalued with no negative credit implications </li></ul></ul></ul><ul><ul><ul><li>The “Holy Grail” of convertible arbitrage </li></ul></ul></ul><ul><li>Over 20-year period, US converts essentially provided: </li></ul><ul><ul><li>Same total returns as stocks </li></ul></ul><ul><ul><li>Half the volatility </li></ul></ul><ul><li>Performance-chasing by funds-of-funds 2002-3 </li></ul><ul><li>Issuance to meet demand as always (largely by better credits, less “vig”, “all arbed out,” league-table loss leaders) </li></ul><ul><li>The saga of Mandalay Bay </li></ul><ul><ul><li>2003: Dividend (you messed up, you trusted us) </li></ul></ul><ul><ul><li>2004: Cash takeover (leads to protection for winning stocks) </li></ul></ul>
  13. 13. 2005: AN “in your face” ODYSSEY
  14. 14. 2005: AN “in your face” ODYSSEY <ul><li>Followed upon two years of flattish performance, down in many cases </li></ul><ul><li>Those two years coincided with turnaround in stock markets </li></ul><ul><li>From perspective of hedged portfolio (stocks, bonds, commodities, real estate, convertibles, timber, etc.), should not have been that surprising </li></ul><ul><li>But … as so often happens… was viewed in a vacuum…flip side of several years earlier </li></ul><ul><li>Rumors of mass redemptions in 2004 did not jibe with performance, but in early 2005… </li></ul>
  15. 15. 2005: AN “in your face” ODYSSEY <ul><li>Some funds of funds managed based on valuation; most did based on what they heard others were doing…despite </li></ul><ul><ul><li>Major structural improvements (thanks largely to Mandalay Bay) </li></ul></ul><ul><ul><li>Powerful mean-reverting properties based on return of capital </li></ul></ul><ul><ul><li>“ Other than price, what has changed?” </li></ul></ul><ul><ul><ul><li>Yes, a senior “investment professional” did ask me that… </li></ul></ul></ul><ul><ul><ul><li>Asset class…particularly in arbitrage sense…not dependent on “greater fool” theory </li></ul></ul></ul><ul><ul><li>“ I’ll get back in when it’s become more fashionable” </li></ul></ul><ul><ul><li>“ Our reason coexists with our insanity” </li></ul></ul><ul><li>Funds flows </li></ul><ul><ul><li>Out of relative-value/market neutral (convertible arb, fixed-income arb) </li></ul></ul><ul><ul><li>Into more active selection process (long/short equity, global macro) </li></ul></ul><ul><ul><li>Following volatility lower and lower </li></ul></ul><ul><ul><ul><li>VIX partially overrated, nonetheless lowest in 15 years </li></ul></ul></ul><ul><ul><ul><li>Similar for fixed-income volatility </li></ul></ul></ul>
  16. 16. 2005: AN “in your face” ODYSSEY <ul><li>Convertible arbitrage “Most hated nation” by 87% of funds-of-funds polled in April 2005 </li></ul><ul><li>Incentives of most asset allocators: more to lose on downside than gain on upside </li></ul><ul><li>Meetings supposedly for in-depth trade discussion became “when does selling stop?” </li></ul><ul><li>Spring 2005: anecdotally worst time since 1970’s (or earlier!) for convertibles </li></ul><ul><li>Locking in big losses for investors </li></ul><ul><ul><li>Redeem from convertible-arbitrage fund with large drawdown </li></ul></ul><ul><ul><li>Pay bigger transaction costs (dealer spreads) that come with unhealthy markets </li></ul></ul><ul><ul><li>End up owning same securities by transferring redeemed funds into multi-strategy funds that purchase the convertibles, but…without old watermark! </li></ul></ul><ul><ul><li>“ In the tidal destruction, the moral melee…” (thanks, Ian/Jethro) </li></ul></ul>
  17. 17. 2005: AN “in your face” ODYSSEY <ul><li>Selling dries up mid-May after redemption deadline, kicks in late-September through mid-Nov </li></ul><ul><li>Bottom line: Tremendous opportunity for investors with longer horizons! </li></ul><ul><li>While a significant portion of the opportunity has been recaptured already, a meaningful part is still there </li></ul><ul><ul><li>Key: Value in keeping abreast of market tone </li></ul></ul><ul><ul><li>Relationships and proper horizon  winning results </li></ul></ul>
  18. 18. HALF-TRUTHS <ul><li>How easy to hedge…and thus, is it as truly a derivative? </li></ul><ul><ul><li>As time horizon expands, broad-scale hedging starts to make more sense </li></ul></ul><ul><ul><li>Do extra layers of hedges do more harm than good if capital is fleeting and transaction costs are high (spreads not commissions)? </li></ul></ul><ul><ul><li>Smaller issues intrinsically more difficult to hedge </li></ul></ul><ul><ul><li>Markets far less “complete” than outsiders think </li></ul></ul><ul><li>Volatility and credit…all you know, all you need to know? NOT </li></ul><ul><ul><li>Busted converts = short volatility (no news is good news) </li></ul></ul><ul><ul><li>How does the interplay work? When can you separate, when can’t you? </li></ul></ul><ul><li>Equity and debt as building blocks vs. converts </li></ul><ul><li>Ability to allocate returns </li></ul><ul><ul><li>“ Standstill” for arbs actually involves trading to offset time decay </li></ul></ul><ul><ul><li>Yet, “gamma trading” (i.e. constant re-hedging) is overrated </li></ul></ul><ul><ul><ul><li>Embedded options are long-lived </li></ul></ul></ul><ul><ul><ul><li>See my basketball/options treatise </li></ul></ul></ul>
  19. 19. HOW OPPORTUNITIES ARISE <ul><li>NEW ISSUES </li></ul><ul><ul><li>Opportunity when the company really wants, but doesn’t absolutely positively need, the money </li></ul></ul><ul><ul><li>Company needs to sell at discount to “fair value” to raise big block of capital </li></ul></ul><ul><ul><li>Issue after stock has had good run </li></ul></ul><ul><ul><ul><li>Attractive to arbs </li></ul></ul></ul><ul><ul><ul><li>Arb-selling pressure helps new buyers get in </li></ul></ul></ul><ul><ul><li>New investor base puts less pressure on stock (Jenkins) </li></ul></ul><ul><li>CHANGED PROFILES </li></ul><ul><ul><li>When in doubt, go with the profile and forget the model </li></ul></ul><ul><ul><ul><li>“ Sweet spot” trading between 80-95% of par </li></ul></ul></ul><ul><ul><ul><li>Supply/demand imbalance greatest in this range </li></ul></ul></ul><ul><ul><li>Overnight “gap” moves in stock vs. “dollar-neutral” trading </li></ul></ul><ul><ul><ul><li>How theory gets put into practice </li></ul></ul></ul><ul><ul><ul><li>Importance of fair, reputable dealing in fast markets </li></ul></ul></ul>
  20. 20. HOW OPPORTUNITIES ARISE <ul><li>HORIZON CONFUSION </li></ul><ul><ul><li>Assets with 3-5 year life on average </li></ul></ul><ul><ul><li>Extremely FINITE supply/demand per issue </li></ul></ul><ul><ul><li>Expected to have day-to-day and month-to-month mark-to-market behavior of two-month options where infinite supply can be created </li></ul></ul><ul><ul><ul><li>“ Crunch all you want, we’ll make more” with options; hedge one month/strike with another </li></ul></ul></ul><ul><ul><ul><li>Converts—each has its own personality </li></ul></ul></ul><ul><ul><ul><li>“ We don’t feel like adding another line to our spreadsheet” (top holder of more expensive convert) </li></ul></ul></ul>
  21. 21. WHERE TO NOW? <ul><li>Arbitrage renaissance this year, but… </li></ul><ul><li>Unquestionably better suited to more flexible, longer-term pools of capital </li></ul><ul><ul><li>Capitalize on myopic trading </li></ul></ul><ul><ul><li>General ways of taking advantage of the asset class for unhedged investors </li></ul></ul><ul><ul><ul><li>Enter investment below par (or maintain exposure) after stock decline </li></ul></ul></ul><ul><ul><ul><li>Swap from stock into convertible after stock gain </li></ul></ul></ul><ul><li>Intel issuance highly encouraging </li></ul><ul><li>One man’s opinion: </li></ul><ul><ul><li>2005 a bad blip on the way to long-term development of the asset class </li></ul></ul><ul><ul><li>But, will be long process </li></ul></ul><ul><li>For further information: </li></ul><ul><ul><li>Bill Feingold </li></ul></ul><ul><ul><li>[email_address] </li></ul></ul><ul><ul><li>917-602-1908 </li></ul></ul><ul><ul><li>http://trueconverts.blogspot.com </li></ul></ul><ul><ul><li>All opinions are entirely my own and… </li></ul></ul><ul><ul><li>Do not represent any organizations I have been, or will be, affiliated with </li></ul></ul>
  22. 22. About the Speaker <ul><li>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. </li></ul>

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