“Nobody told me there’d be days like these,” sang John Lennon. Strange days indeed. In truth, though, nothing really beyond the pale has been going on. Painful, yes. Surprising, sure. Beyond astonishing, not really.
The pain in the convertible market this year can be traced more or less directly to one of my favorite quotes about our favorite, however beleaguered, asset class. Back in the dot-com era, the Wall Street Journal columnist Holman Jenkins wrote that what makes convertibles so fascinating is the way they straddle the gap between the “risk-reward” pricing model used for bonds and the “what-the-heck” pricing model. Many convertible issuers—and many more companies that should issue convertibles but, for reasons best known to themselves, do not—are young, fast-growing companies essentially inventing new industries as they go along. Some of these companies reach a point where, despite the massive uncertainty surrounding their appropriate equity valuations, one can arrive at a fair degree of confidence that the businesses will be around for a while.
We’ve been seeing the scary side of that uncertainty in a big way. Look no further than LinkedIn, a company that has largely redefined how professionals connect and how recruiters work. Talk about disruption. But how do you value that? To the naked eye, LinkedIn has appeared richly priced, yet reasonable arguments can be made—even now, even after Friday’s debacle—that the company has barely scratched the surface of what it might achieve.
As down as we all seem to be on convertibles these days, the LinkedIn bond did pretty much exactly what it was supposed to do. It fell by 10% with the underlying shares down a cool 44%--less than 25% of the downside. Now, go back almost exactly a year, when LinkedIn stock was making all-time highs of around $270, or 23% above the stock’s price when the convertible was issued a few months earlier. At the stock’s peak, the convertible was going for around 114% of par. That’s about 60% of the stock’s upside.
Sound roughly familiar and appropriate? Well over half the upside, less than a quarter of the downside? Maybe not quite as snappy as the old two-thirds/one-third refrain, but you get the point. And for those who’ve given up all hope on the convertible-arbitrage business, this event should have been a bit of a tonic. If you had a reasonable hedge around 60% going in, and were patient about buying back shares, you should have had a payday of five points or so.
More broadly speaking, the market’s being quite punitive to convertible issuer types, and not all of them have LinkedIn’s staying power. That said, there are plenty of reasons to see this as a better and better entry point.
For whatever it’s worth, I spoke last week to two long-time acquaintances, both of whom had extensive convertible careers and now work in other fields. One, who’s proven himself in a variety of enterprises and is roughly my age, is buying convertibles now for his own account. The other, nearly a generation younger and just recently departed from the game, thinks the asset class is finished. You decide.
(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).