The first quarter of 2005 was not kind to the convertible market: while multiple forces were responsible for pushing prices down, hedge fund selling caused the most dramatic valuation collapse. During the quarter, the convertible market was impacted by declining equity prices and credit spread widening, as one would expect. However, the dramatic decline in equity volatility (see VIX chart below) and pressure from hedge fund selling caused the convertible market to become significantly undervalued. In fact, our models show such undervaluation at a point not reached since the market crash of 1987, creating buying opportunities.
Our valuation model uses a long-term volatility measure for each company's underlying stock with some adjustments made for balance sheet risk and liquidity risk to reflect current changes to the company. As the chart above shows, we assess that the convertible market's average valuation has traded between 1.5% undervalued and 2.5% overvalued most of the time since 1990, averaging about 1% overpriced. Since August of 2004, however, the average valuation has declined more than 5% to a near-record undervaluation of -3.5%.
The hedge fund community appears to price convertibles on a very short-term volatility basis, causing some long-term buying opportunities such as those we see today.
The hedge fund community's selling of convertibles appears driven by the faltering of convertible arbitrage strategies during the past year. Convertible arbitrage strategies often use the technique of holding long convertible positions combined with shorting the underlying equity positions. Such a hedge neutralizes equity risk while the convertible supplies a yield advantage and the potential to rise in price if its volatility increases. Convertible securities, like call option contracts, increase (decrease) in value when implied volatility increases (decreases) because the probability of the convertible's option being at or above its strike price also increases with a higher implied volatility.
Thus, the hedged position has the potential to deliver additional return if the convertible's implied volatility rises, and the risk of a lower—or negative—return if a convertible's implied volatility declines.
In addition it was not only the decline in volatility and poor performance of convertible hedge products that drove selling in the convertible marketplace during the quarter but also the Fed's short-term rate hikes which increased the cost of borrowing: Because most hedge funds employ leverage (borrow money) to enhance the return potential of the portfolio, the rise in rates also made the potential returns less attractive going forward.
Volatility has been declining, making it difficult for convertible hedge strategies to make money by being long (or 'owning') volatility. Coupled with the fact that yields on convertibles are—like all interest rates—at relative lows, the yield is not that attractive when hedge fund customers expect 20% returns. Additionally, with the trend towards companies raising equity dividends, many positions that are attractive to long convertible buyers become very unattractive to convertible hedgers. For example, if a company raises the stock dividend, the convertible's relative yield advantage is reduced, and the convertible valuation declines while the stock's value may even go up: each factor works against the hedge. Finally, M&A activity has resulted in price rises for some convertibles whose issuers are targets for acquisition, but they have risen less than their underlying common stock. The convertible lags the stock's rise due to conversion premium collapsing. This results in losses for the convertible hedger but a gain for the long buyer, since the convertible still rose in price.
In recognition of what we see as clear market-driven opportunity, we are actively buying convertibles that we believe are at least 5% undervalued and restructuring our portfolios to take advantage of the exceptional risk-reward opportunity in the market today. We do not know how long this valuation gap will last so we are not about to try and time our entry. Instead, we will take advantage of it now, believing that this benefit can be realized by our portfolios at some point in the near future.