Monday, March 05, 2007

Asset Class Reader: Convertible Bonds

Convertible Bonds As An Asset Class 1957-1992 by Ibbotsen, Scott L. Lummer PHD CFA, Mark W. Riepe CFA

Convertible bonds are an important asset class, but its risk and return performance and suitability as an asset class for different types of investors has received insufficient attention. We attempt to rectify this neglect by evaluating the unique characteristics of convertibles and documenting the convertible bond market in terms of its historical return performance. We find that convertibles allow the investor to experience the benefits from both a fixed-income and equity investment, have favorable features for issuers who are consequently motivated to price the bonds attractively, and are ideally suited for an investment in firms whose future risk is difficult to assess. With respect to performance, convertibles had a compound annual total return of 8.3 percent over the years 1957 to 1992 compared with 6.8 percent for long-term corporate bonds, 7.3 percent for intermediate-term corporate bonds, and 10.5 percent for stocks.
What Drives the Performance of Convertible Bond Funds?

Ammann, Manuel, Kind, Axel H. and Seiz, Ralf, "What Drives the Performance of Convertible Bond Funds?" (March 2007)

This paper examines the performance of US mutual funds investing primarily in convertible bonds. Although convertible-bond funds are popular investment vehicles, their return process is not well understood. We contribute an analysis of the complete universe of US convertible-bond funds proposing a set of multi-factor models for the return generating process. In spite of the well-known hybrid nature of convertible bonds, the return process of convertible-bond funds cannot be fully explained by factors typically related to stock and bond markets. Thus, we consider additional variables accounting for the option-like character of convertible bonds. Surprisingly, multivariate cross-sectional analyses show the existence of a significant positive relationship between fund's performance and its asset composition. We show that this result can be explained by factors related to investment opportunities in the convertible-bond market and trading strategies related to convertible arbitrage, as typically performed by hedge funds. Overall, convertible-bond funds have a performance as measured by alpha that is comparable to passive investment strategies in stocks, bonds, and convertible-bonds. This average performance is the result of weak selection skills and successful timing in trading strategies closely related to convertible arbitrage.

An Empirical Comparison of Convertible Bond Valuation Models

Zabolotnyuk, Yuriy, Jones, Robert A. and Veld, Chris H., "An Empirical Comparison of Convertible Bond Valuation Models" (June 18, 2007)

This paper empirically compares four convertible bond valuation models. We use an innovative approach where all model parameters are estimated by the Marquardt algorithm using a subsample of convertible bond prices. The model parameters are then used for out-of-sample forecasts of convertible bond prices. The mean absolute deviation, which is calculated as the absolute difference between the model and the market price expressed as a percentage of the market price, is 2.29% for two different versions of the Tsiveriotis-Fernandes (1998) model, 3.08% for the Brennan-Schwartz (1980) model, 3.19% for the Takahashi-Kobayashi-Nakagawa (2001) model, and 4.08% for the total default and the partial default Ayache-Forsyth-Vetzal (2003) models. For this and other measures of fit the Tsiveriotis-Fernandes model outperforms the other three models.