In our last discussion about convertible bonds, we covered the topic of valuation, and hope that we cleared up some of the complexity of the subject.
We would like to perform a similar exercise for the notion of volatility and describe why it can be a good thing for convertible investors. After a brief refresher on definitions of volatility, we will cover:
- Why convertibles work in a volatile market
- Why does our process benefit from volatility
- Why can expensive convertibles still be attractive
- Is higher volatility here to stay?
What is volatility, and is it something I want…or not?
For the mathematically minded, volatility is a measure of dispersion. That is, if a mean value is known or forecast, volatility shows the range of potential returns around that central value. Or to put it another way, a higher value for volatility means more uncertainty about the future. That also means a greater chance of a good or bad outcome for an asset.
So, is higher volatility a good thing for investors? We noted in our previous discussion that volatility is an input into the option pricing formula. All else equal, a higher volatility input means that a call option, which is what is embedded within a convertible bond, becomes more valuable.
But to answer this question in real-world terms, we need to remember that usually one must take on risk to be able to earn a return. Higher volatility is the cost of that having that chance. The real answer about whether high volatility is good or not depends on how much investors are exposed to damage, compared with the potential gains to be made from that investment.
Why convertibles work in a volatile market
Let’s look quickly at the concept that a higher input for volatility makes a call option more valuable. Why would that be the case, given that greater uncertainty means there is also a higher chance of a bad outcome?
Options can have an asymmetric payoff, where for an equal move up or down in an underlying stock, the gains from upside participation outweigh the losses on the downside. We can also refer to this asymmetric payoff as convexity. Simply put, if an underlying stock rises in value, the option participates in those gains, but if it falls, the option will have already moved to an out-of-the-money, low-premium state, while the stock can keep on falling. Convertible investors also hold debt of the issuer that must be repaid or refinanced, which adds further downside protection for investors.
Of course, a loss is a loss, but compared with holding stock directly, options or convertible bonds provide more potential convexity. In that way, rising volatility leads to market conditions that favour optionality. Or, if issuers using convertibles for financing are offering an embedded option to investors, that option becomes more valuable with rising volatility.
Why does our process benefit from volatility?
If we all knew which direction markets were likely to take, and they followed a predictable course to reach that outcome, investing would be simple. But of course, it isn’t that easy. And if volatility rises, markets can change course not only quickly, but also unpredictably.
As convertible investors, we have an extra benefit in being able to shape our investments and portfolios to achieve greater convexity of returns. That removes much of the unwanted risk from an incorrect market timing call in a more volatile market.
Rebalancing our portfolios is a key part of our investment process that allows us to maintain convexity. As individual holdings rise in value, they gain more sensitivity to the underlying stock, and become less convex. Or, if a holding has become too bond-like, it has little convexity unless that underlying stock gains massively in value. By trimming these types of positions and shifting into more convex holdings, we ensure that our portfolios are not too equity-like following a rally and at risk from a correction, or too bond-like and unable to participate in a bounce back.
When markets are more volatile, we tend to see more of this rebalancing activity as underlying stocks move in a wider range. Also, rising volatility has often coincided with rising issuance of new convertible bonds. Because most new issues are structured to provide convexity to investors, we have more opportunities to either take profits or redeploy out of bond-like holdings.
Why can expensive convertibles still be attractive?
In our view, we see that many convertible investors can get fixated on comparing implied volatility, that is, using the price of the option to back out a volatility figure with realised or forecast volatility. Understanding volatility with convertibles also involves knowing when to be flexible about valuation, given that this factor is not the main source of returns under our investment process. We want our investment process to be disciplined, but not rigid and constrained.
It’s true that nobody wants to overpay, particularly not for an investment. But we are directional investors, not volatility forecasters, and we are using convertibles to take a view on an underlying stock, knowing that we have downside protection from the bond component.
If we see a position with an implied volatility that seems high relative to its potential volatility, we need to consider how much the underlying stock could rise in an upside case, while adjusting that total return downward as the rich option converges with a fair value. For a convertible that still offers convexity after that adjustment to total return, we could still justify a position. And there are often bonds that do trade with a premium to option-implied fair value for any number of reasons.
Is higher volatility here to stay?
We do see that higher volatility, at least, when compared with the low-volatility conditions experienced during the 2010s, is here to stay for a while. There are several reasons behind this shift, and we outline a few here:
- Greater uncertainty because of the coronavirus pandemic (lockdowns, mutant strains)
- Structural changes to the economy related to the pandemic
- The possibility of rising bond yields, which tend to be correlated with higher volatility
- Continuing demand for growth-focused investments that are higher volatility in nature
- Valuations for stocks at all-time highs; credit spreads also at historically tight levels