Two of my great loves, as readers of these pages know, are horse racing and convertible bonds. Yesterday I made up for missing the Belmont Stakes in person by taking my family down to the Jersey Shore to see American Pharoah win the Haskell Stakes. What a magnificent horse. He doesn’t look spectacular before the race—average size and remarkably calm. But let the starting gate open and he’s all business. He made some good horses look very bad yesterday. His jockey, my friend Victor Espinoza, was virtually standing up on him the last eighth of a mile, making it look like to the untrained eye that second- place Keen Ice might catch him. Not a chance.
What makes the horse so great? He’s what horse people call “push-button.” He gets himself into position to win the race on his own and then just waits for his jockey to let him know when to take off—usually with about a quarter of a mile left in the race.
Convertible bonds are, for the most part, push-button instruments, at least when you use them correctly. True, you can’t buy or sell a convertible by clicking on a link in an online trading account. Well, maybe you can, but I wouldn’t advise it. Then again, one of the few things American Pharoah can’t do is put on his own equipment and find the way into the starting gate on his own. So maybe that’s the right analogy. Buying the bond is like getting the horse into the starting gate. From that point on, it’s pretty automatic.
What’s the equivalent of the jockey saying “go” on the far turn? I guess it’s when the convertible gets to that tricky point in the 120’s or 130’s where there’s still plenty of premium to chew up. As Robert Plant sang, “there are two paths that you can go by, but in the long run, there’s still time to change the road you’re on.” Do you ride on for the big win, deciding the premium is just a necessary evil en route to much greater gains? Or do you take the cautious road, selling and moving on to the next trade? It’s up to the convertible jockey, the portfolio manager, to have a feel for how much run the horse still has. We like to think HARP and HOCS can be useful tools in mapping out your ride.
Of course, the ideal convertible jockey has the option to switch horses mid-race. If you still like the upside of the story but no longer favor the convertible’s profile, you can switch into stock, or options, or some mix thereof. If you think the premium is too low, but you’re worried that the horse is tired, hedging by shorting stock makes the most sense.
In horse racing, they say, “breed the best to the best and hope for the best.” American Pharoah’s breeder, who still owns him, bred very good to pretty good and got the best. His father ran second in the Kentucky Derby. His mother only raced twice and did not win, but was bred to be fast. With convertibles, you breed a healthy credit to a volatile stock and hope for the best. You can win, of course, with other recipes, but it’s not as likely. Either way, the jockey is mostly along for the ride, except for one or two critical decisions. May the horse be with you.
(This is the cover letter for the subscription-based weekly Hillside's Hybrid Vigor newsletter. For a complete copy, please contact John Anderson at + 1 (646) 712-9289 x 107).