In today's market environment, uncertainty is widespread.
With some equity, credit and interest rate markets stretched, downside risks significantly outweigh upside potential.
For investors seeking to protect their portfolios against these downside risks without having to forgo gains to the upside, hedged convertible bonds could present a solution.
Within hedged convertibles strategies, specifically convertible arbitrage strategies, a long convertible bond position is paired with a short stock position in the same company.
In rising markets, the long convertible bond position, because of its asymmetric return profile, will typically make more than the short stock position loses.
In falling markets, the long convertible bond position, again because of its asymmetric return profile, will typically lose less than the short stock position makes.
As such, hedged convertibles can offer investors the ability to generate returns in both up and down markets, in addition to monetising periods of sustained market volatility.
This source of returns, also known as volatility yield, supplements the traditional drivers of return to fixed income investments and so may allow for greater return potential versus traditional fixed income securities.
While the potential for return generation via hedged convertibles is quite compelling, what is particularly relevant are the risks taken in order to achieve this return potential.
In the case of convertible arbitrage strategies, position-level hedges not only serve as a source of returns, but they also reduce the chances of capital impairment.
For every one dollar invested in traditional fixed income securities, investors have one dollar of risk, as this does not represent a hedged value proposition.
Conversely, for every one dollar of exposure invested in hedged convertibles, approximately half the risk can be hedged with a corresponding, short stock position in the same company.
The ability to hedge credit risk with a short stock position in the equity of the same company means that hedged convertibles could offer greater return potential compared to similar high-yield issuers, with roughly half the credit risk.
Sarah George is client portfolio manager at Lazard Asset Management
• Hedged convertibles able to provide increased return potential through the monetisation of market volatility
• Hedged convertibles also provide investors with downside protection
• Convertibles typically offer a lower coupon than high-yield securities, but hedged convertibles provide an additional source of returns that can increase return and reduce credit risk