Francesco Barrai has been investing in convertible bonds (CBs) for 10 years, initially out of New York, then in London and India, before moving to Hong Kong four years ago. He makes equity-linked investments for DE Shaw across Asia, Japan and Australia.
The firm manages roughly $21 billion through a multi-strategy platform that comprises both fundamental and quantitative strategies, of which CBs is one.
What type of CB investor is DE Shaw?
We don’t see ourselves as classic convertible arbitrage investors. We have a mandate that is market neutral so our portfolio needs to be largely hedged to market risk, but we don’t always need to hedge positions on a name-by-name basis.
Sometimes hedging at the overall portfolio level, rather than robotically hedging at the security level, can be a more efficient use of capital and can minimise transaction costs. Because we have refined risk management systems, we can accept risks where we believe we’re well compensated for them. How cheaply a bond models up in a CB pricing framework is an important parameter, but we also look at the equity story, the credit story, and upcoming special situations.
We invest across the liquidity spectrum and have significant experience investing in private convertible bonds. Everything else being equal we prefer more liquid investments, but if we are being compensated for the exposure, then illiquid bonds can offer opportunities as well. We are always prepared to keep the bonds until maturity, but we constantly rebalance and revaluate our position in response to market conditions and to optimise our portfolio, so our average investment profile can be significantly shorter than that — from one month to one year.
What are the key things you look for when deciding whether to invest in a new CB issue?
The first thing we look at is what it is we are forming our opinion on. What are the unknowns? What type of wager are we making? Assuming we can trust the financial data that the company is providing, what is the bet we are making? Is it predominantly a credit bet, a stock bet, a volatility bet, a CB sentiment reversal bet, or is there some event there? Can we hedge any of the components? Obviously we look at the quality of the issuer as well.
Since the global financial crisis investors like us are more careful about being at the receiving end of adverse selection, which essentially means when the issuer and the investor have asymmetric information. That can be a challenge in Asia. We are very careful about jurisdictions that have weaker investor protection and bonds with weaker covenants.
What makes a good CB investor in Asia?
Since a CB is a hybrid product, you need expertise in equity, credit, FX, interest rates and volatility pricing. We have a lot of mathematical and technical talent, but in Asia you also need local market expertise and rigorous fundamental analysis skills.
Returns are not only generated by mispriced securities, but by avoiding pitfalls. That is really more an art than a science, but you do need local contacts and rigorous local due diligence. We have over two decades of experience in trading and investing in equity-linked products in Asia and that makes a difference. It also helps to have a counter-cyclical mindset and a strong balance sheet to take advantage of opportunities when there is a sell-off in the market.
Since the financial crisis, long-only investors have become bigger buyers of CBs. What impact is that having on the market?
There are many different types of outright investors. There are the traditional CB outright investors that have a dedicated outright fund, and private banks or high-net-worth individuals that came after the credit crisis and have been very active on the buy side since 2009. But there are also non-traditional CB investors like equity and credit accounts that play CBs.
So it’s difficult to lump them together and have a unique theme, but the way we look at it is that hedge funds and long-only investors have very different, but sometimes complementary, utility functions. That creates an interesting dynamic in the market since you have different people responding to different investment philosophies. Right now we estimate that about 70% of the Asian CB universe is owned by what we call outright investors. In the primary market, they buy into a fundamental equity story and they want a certain balanced profile with some yield.
In the secondary market, outrights tend to be liquidity-seeking and to trade when there is a clear trend in the market, up or down. They are less active when the direction is less certain. Hedge funds sometimes show the opposite behaviour. We are more counter-cyclical liquidity providers. Regardless of ownership percentage, the market hasn’t got rid of instability just because fewer leveraged arbitrage funds own CBs. No class of market player is immune from panic selling.
What trends do you see in the market at the moment?
For the past one or two months there has been a bit of weakness. It is not surprising and it is not unique to the asset class itself — it is more macro and related to things like the Chinese corporate governance headline risk, the European sovereign risk and the US debt ceiling. We think it is a good time to buy bonds for those who can take advantage of market dislocations. We are currently seeing attractive valuations in the Asian CB market, although the macro headline risk is still high so there is significant volatility.
Some people are sitting on their hands and are afraid to buy because the macro worry may continue. Another thing is that new issues, even the most balanced and hedgeable names, have seen some rough performance in the aftermarket, which has taken time to absorb. Although there haven’t been big selloffs, we have observed new issues trading flat or down despite being priced with more investor-friendly terms than they were six-to-eight months ago. Again, this could be a good opportunity for us. If past experience is any guide for the future, valuations will normalise.
What other themes do you expect going forward?
It has been a year with lots of new issuance, but the rest of 2011 and 2012 will see $25 billion of redemptions so we will need substantial new issuance just to offset that.
Refinancings in the Indian CB market will be big, but investors will be very selective because of the adverse selection issues I was referring to before. Judging from the filings we have seen in Taiwan and Korea there will be some paper coming out there, possibly in domestic currencies.
If the NDS [non-deliverable swap] curve remains negative, there will still be advantages for domestic issuers to issue in local currency. And China mid-caps will probably try to come back to the CNY market.
In the past 12 months, straight debt issuance has been predominant, partly because issuers are less willing to sell CBs if share prices are low. But right now, credit spreads are starting to widen, volatility is slowly ticking up and interest rates are still very low, which means the whole environment is becoming more conducive to large caps using CBs as a funding tool.
Chinese companies account for a big portion of CB issuance in Asia. How are the reports about weak corporate governance influencing your investment decisions?
Corporate governance issues are not new to the market — remember the scandals involving S-chips [Chinese companies listed in Singapore] and Asia Aluminum a few years ago. I think the reason they are a bit more in the spotlight now is because they involve US-listed companies. Both low-quality and high-quality paper have been sold off, especially out-of-the-money Chinese mid-cap CBs, and that has created opportunities for the discerning investor who has a local presence and can do the work. The CB market is very sentiment driven, and trading sentiment is something we do well.
This article first appeared in the August 2011 issue of FinanceAsia magazine