As part of my role as self-appointed ambassador for the convertible asset class, I frequently give lectures to undergraduates and graduate students, trying to explain the basic elements of convertibles and the areas where practitioners punch holes in the general theory. One question I often ask, after establishing that students have a basic understanding of options, is whether traditional corporate bonds are effectively long or short the volatility of the issuer’s underlying business.
Sometimes the students just guess, being still only vaguely familiar with what it really means to be long (or short) volatility. Sometimes they confuse the volatility of interest rates with that of fundamentals (and stock prices). But usually they get it right. Once asked, they recognize that owning a traditional corporate bond almost always amounts to a short volatility position in the underlying assets. Things going really right can only help, at most, a little: things going really wrong can hurt a lot.
I do this when I teach in order to help students understand that volatility, as it relates to convertible bonds, is not as simple as conventional wisdom would like it to be. I’ll never forget having an asset allocator unhappy with my performance tell me he was “penalized” for using convertibles as a long-volatility strategy, even though I had urged him to consider the nuances involved. I tell students that while (happily) most convertibles never reach that steep dropoff at the far left of the chart, where the stock price approaches zero, the possibility that they might affects performance every day— and that the handling of that possibility is what ultimately defines most successful managers.
This line of thought deserves consideration in light of the challenges now plaguing the high-yield market. Some have wondered how the equity indices, despite their recent downturn, can possibly be outperforming high yield this year. What’s bad for high yield, the thinking goes, should be even worse for stocks. This makes the fatal error of assuming the starting prices were somehow “right”—that old efficient-market bugaboo. If in fact high yield started out overvalued, considering that it’s a short-volatility asset class that stands to lose more than it might gain from big moves, while equities were priced more appropriately given their risk-reward possibilities, it’s entirely logical that stocks can outperform credit going from Point A to Point B. As always, price matters.
Most of the investing world probably knows, collectively, less than a certain venerable high-yield manager has forgotten. This manager showed unusual integrity in the past year or two, encouraging investors to take money out of his firm’s flagship fund because of the overvaluation he perceived in the high-yield market. Now he’s saying it’s time to get back in. It makes sense to pay attention.
(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).