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Convertible appeal

To state the obvious, anything with a yield these days seems to be drawing attention. There has been a raft of equity income fund launches and a stunning £3bn in net inflows into bond asset classes in the first two months of the year, high-lighting the strong appeal of yield.

There is no denying the attention being given to equity income and corporate bonds but there are also a few things between these two centre points of interest which feature yield potential.

Convertibles have been around for some time but have never really captured too much retail investment attention. But these days, in the hunt for yield, both equity and bond managers are examining the opportunities that this space is offering.

The middle ground of convertibles may have been an area best avoided, particularly in 2008, but market forces in recent months appear to have painted a more attractive picture for this asset class than has been seen in some time. Now both equity and bond managers are seeing the appeal of this middle ground – bridging the gap between equity and fixed interest.

According to M&G global convertibles fund manager Leonard Vinville, conver-tibles typically offer the best of both worlds – participation in equity market upswings but in times of turmoil they can act like a bond, offering some amount of protection on the downside.

Typically, convertibles have never been a big part of either bond or equity funds in the UK retail sector as they often trade at a higher price than buying a bond. Fixed-interest managers shun them as they offer a lower yield than buying the straight bond and they have no interest in the equity while the reverse is true for equity managers.

Last year was disastrous for convertibles. F&C global convertible bond fund manager Anja Eijking says when hedge funds and banks sold off their holdings in corporate bonds last year, the convertible market repriced in an unprec- edented way and prices fell further than equity markets.

Eijking says: “However, the disappointing absolute performance of the asset class has its benefits as it now offers very attractive investment opportunities with limited risk and attractive upside potential in the wake of the sell-off.”

Unprecedented cheap valuations mean that many convertibles are offering cheap options to convert to shares but still feature a bond-like yield. Vinville says: “Convertibles, just like corporate bonds, are curr-ently showing extremely good value and are cheap on a number of measures.”

Many convertibles today are “busted” as a result of 2008’s events. This means the option to convert to equity is no longer a drag on the yield. In many ways, the busted convertibles are offering the best of both worlds – the yield of a corporate bond, giving investors an income but it can switch to equity when the market recovers, providing capital uplift. In many cases, the options for equity conversion are so low that some busted convertibles are said to effectively be offering yield plus a free equity option.

Alan van der Kamp, portfolio marketing manager at F&C, says that for bond managers, the appeal of convertibles is a stable yield plus what looks to be a free equity option while for equity managers contending with volatility and uncertain dividend streams, they can access yields of around 8 per cent but still take part in an equity recovery.

He says: “Since the end of October, convertibles have seen a lot of attention.”

Standard Life Investment’s new European income fund intends to opportunistically invest in the convertible market to take advantage of some of the interesting running yields on offer.

Will James, portfolio manager of the Standard Life European equity income fund, says the coupons on offer for some convertibles are higher than could be received from the underlying equity itself. James believes the attractions of this asset class remain very stock-specific but he notes that the current environment has created a window of opportunity in this space which he believes could be around for the next six to 12 months.

Equity prices have recently gained ground but there remains a question as to whether it is a bear market rally or the beginnings of a sustained recovery. James says: “Convertibles are a good way to play that kind of market. We essentially get paid to wait. We get a bit of downside protection but also have upside potential.”

Eijking says: “Convertibles offer some 10 per cent yield to maturity and about 40 per cent equity participation in recovering equity markets. With this in mind and following the extreme sell-off in the convertible markets, convertibles provide an attractive investment opportunity to participate in recovering capital markets in a risk-reduced manner.”

Van der Kamp says new issuance of convertibles has been strong and he expects this is likely to continue through to the summer as long as the current equity markets hold up. James also notes that there has been attractive new issuance in this sector, pointing out that there are strong names coming to this marketConsidering the horrid 2008 period for convertibles, there remain serious liquidity issues with this area of the market. However, James says opportunistically there are attractive areas. “I would not pile in. We need to make sure that the underlying issuer is someone we like.”

Yield holds appeal for nervous and equity-shy investors, as shown by the massive inflows into the bond sectors. However, investors, fund managers and intermediaries alike may be starting to look around at some of the other yield opportunities being presented.

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