A haven from volatility

PUBLISHED : Tuesday, 26 June, 2007, 12:00am
UPDATED : Tuesday, 26 June, 2007, 12:00am

A SUSTAINED BULL run on regional stock markets has helped develop Hong Kong investors' appetite for equity-linked derivatives, as markets brace for a possible correction.

But wealth managers say with interest rate rises in the pipeline, investors seeking a haven from possible equity market volatility may begin to switch their attention to convertible bonds.

Mark te Riele, chief executive of Fortis Investments Hong Kong, says convertibles should have a weighting of about 5 per cent in a diversified global portfolio of investments.

While there is no hard data on the use made of convertibles by Hong Kong's high-net-worth individuals, anecdotal evidence suggests the penetration of such products is low compared with the developed wealth markets of Europe and the United States, he says.

'At present investors are focused on equities because of the outstanding performance of markets such as China and India. But in the event of a correction to these markets, investors will likely look at other asset classes and pay more attention to convertibles, which provide an attractive combination of exposure to upside gains from underlying equities while incorporating the safety that bonds offer.'

Fortis Investments is a major convertible player in Europe he says, and manages a global convertible fund now valued at about Euro2.5 billion (HK$26 billion). The firm launched a convertible Asian bond fund in March last year that has attracted about Euro140 million in subscriptions.

'We have detected a lot of interest from Hong Kong distributors in the fund, but it is a little early to say how responsive Hong Kong investors may be to the idea of making more use of convertibles,' he says.

The attraction of a convertible bond during turbulence on equity markets is that it may offer investors the opportunity to make gains if the value of the underlying stock or basket of stocks goes up, but will protect the bondholders from losses.

Take a simplified textbook illustration of a five-year convertible bond issued at a subscription price of HK$100 and offering a small coupon rate of interest of 2 per cent.

The attraction to the issuer of the bond is that capital may be raised at a discount to the yields at which such paper may be trading in the conventional bond market, of say 4 per cent. The attraction to the investor is that in return for accepting the reduced yield, there is a prospect of banking a capital gain on conversion of the bond into the underlying equity. An investor in such a convertible bond is required to take a view on what is likely to happen to the price of the share or basket of shares on which the contract is written.

The 'exercise' price at which the bond may be converted into the share or shares will always be above the price ruling at the time the bond is issued. If the price is too far above its historical trading range there will probably be no conversion and no capital gain, and the bond will trade at its issue price until maturity, leaving the investor with just the underperforming interest coupon and intact principal.

The concept of a stock 'beta' therefore becomes useful in gauging the likely performance of the convertible bond.

Across the product spectrum an investor may find convertible bonds that perform like a pure bond in the event that the price at which the underlying share is trading is well below the exercise price at which the bond may be converted into those shares. In this case the investor will enjoy only the coupon rate of interest attached to the convertible bond, though in the absence of a default by the issuer, will recover the principal at maturity.

At the other extreme are convertibles written against equities or a basket of equities that may trade well above the exercise price written into the contracts and which will therefore trade more like pure equities.

Mr Te Riele says Fortis Investments operates somewhere in the middle of these two extremes.

'We have built a strong capability and have become one of the biggest in Europe by having a very structured process and bargaining power. Scale is an important element when it comes to issuance of convertible bonds, particularly products written on initial public offerings.'

But Hong Kong investors have turned to equity-linked derivatives in preference to convertible bonds. Industry sources estimate sales of all structured products to Hong Kong retail investors amount to about US$75 billion a year, of which convertible bonds account for a fraction.

According to Bruno Lee Kam-wing, HSBC's head of wealth management, personal financial services (Asia-Pacific), the bulk of investment inflows into structured products in Hong Kong is directed at a wide array of equity-linked investment products offered with or without principal protection and tailored to produce returns linked to single-name stocks, baskets of stocks or stock indexes, or shifts in interest rates or currencies.

That observation is supported by data published by Hong Kong Exchanges, which shows that index and stock options accounted for 99.7 per cent of turnover volumes in listed derivative products during the 12-month period to June last year, with stock options the most active options product contributing 79 per cent of total options contract volumes.

'As a general rule, when the stock market is performing, well-structured equity products are not that popular because in these market conditions people opt to invest directly in equities,' Mr Lee says.

'It is when people are either sitting on the sidelines or have a mixed view on the correct moment to enter the market due to concerns over volatility, that they may be tempted to use an equity-linked structured note,' he says.

In these circumstances equity-linked investment products are attractive, he says, and among the most popular of the products distributed by HSBC are non-principal protected Bull Equity Linked notes.

Better with Beta?

Beta provides a predictive measure, based on historical relationships, of how a stock or a basket of stocks will perform in the future relative to the performance of the market as a whole, or the sector in which it trades.

The measure, also known as the beta coefficient, is calculated by plotting actual share prices at any given index price on a chart, with the dependent variable (the share price), on the Y axis of the graph, and the independent variable (the index price), on the X axis, and then finding a straight line that best fits through the scatterplot and draws the mathematical relationship between the two.

This is known as a simple linear regression and in this case will indicate by how much the share price is most likely to change for any given change in the value of the index.

A steep line (above one), will mean a relatively bigger change in the share price for any given change in the index, and such a stock will have a high beta or a tendency to show much bigger swings than the market. For example, if a share's beta is 1.2, it is theoretically 20 per cent more volatile than the market. A beta of less than one therefore means that the share price will be less volatile than the market.

Typically blue-chip stocks, banks and utilities, for example, will have betas of one or below one, while small cap or speculative stocks will have betas of greater than one.

Based on this example, if the stock underlying a convertible bond or an equity-linked note has a low beta and the exercise price at which the contract may be converted into the underlying shares is significantly higher than the spot share price at the time of issue, the prospect of a capital gain on conversion is poor.

Alternatively, if the beta is positive or high and the exercise price of the derivative contract is close to the spot price of the underlying security or securities, then there is a reasonable prospect of converting at a capital gain (though in a falling market there could also be a higher prospect of booking a loss if the contract doesn't include principal protection).