Cautious optimism converts investors to convertible

LONDON (Reuters) - A mood of cautious optimism tinged with nagging doubts about economic and credit risks is driving investors towards convertible bonds as a way of tapping into rising equities with a degree of protection.

Firms such as HSBC Investments and F&C Investments are listing convertibles among their current favorite assets, while others such as JPMorgan Asset Management are launching new convertible bond funds to exploit demand.

Convertibles come in various forms, but they are essentially bonds issued by a company with the right to swap later for equities. Typically, the bond pays a lower coupon than regular debt, but the equities are offered at a discount.

A recent seven-year euro bond sold by International Power (IPR.L), for example, offered a 4.75 percent coupon -- only around 80 basis points more than the yield on the government equivalent.

For companies, issuing a convertible bond is a way of raising money relatively quickly and relatively cheaply.

As a junk-rated borrower, International Power could have expected to pay nearly 400 basis points over government debt for a traditional bond, according to data from Merrill Lynch.

For investors, however, convertibles offer cautious diversification with the prospect of good profits.

First, there is the guaranteed coupon. Second, buyers of the International Power bond can convert the paper into shares at 5.7222 pounds, some 35 percent above the reference share price at the bond's issue.

In other words, any rise above 35 percent over the seven-year life of the bond hands the investor a bargain.

"You get more or less the same return in the long run as equities but with less volatility," said Charlie Morris, head of absolute returns at HSBC Investments.

Morris's most immediate clients are interested in capital preservation with prospects of growth, hence the attraction of a bond with the option of discounted equities at a later date.

Others are looking at convertibles within the current environment of skittish financial markets making tentative attempts to recover from nearly a year of turmoil.

F&C, for example, is positive about the long-term investment outlook, seeing only a short recession in the U.S. economy. But it is cautious, expecting more volatility.

"The risk/reward profile of convertibles continues to be very favorable," it said in a note.

DIVERSITY

How well convertible bonds perform depends on the merits of individual issues, but there is some evidence that as a whole the asset class has been bettering equities when they are falling and matching them when they rise.

Lehman Brothers' composite U.S. convertibles index has lost around 0.3 percent year-to-date versus a loss of around 4.5 percent for a broad U.S. stock equivalent, the S&P 500 .SPX.

Both gained around 4.75 percent in April when equities put in one of their best showings in years.

Compared with investment grade corporate credit, meanwhile, convertibles failed to beat a year-to-date gain of more than 1 percent, calculated by Merrill Lynch, but outshone April's showing of just 0.57 percent.

"The mixed feature between credit and equities is attractive. They are an attractive diversifier," said Emiel van den Heiligenberg, head of tactical allocation at Fortis Investments.

Fortis likes convertibles for its clients on a long-term, strategic basis, but van den Heiligenberg said there were also shorter-term, tactical reasons for investing in the asset.

"Convertibles are tactically attractive because volatility could easily rise ... and issuance has been positive," he said.

JPMorgan Asset Management would appear to agree. It is in the process of adding to its convertibles stable with a closed-end fund on the London Stock Exchange for UK market players.

CAUTIOUS OPTIMISTS

HSBC's Morris reckons one big plus for convertibles at the moment is that they are cheap, mainly because proprietary trading desks at investment banks and other institutions have been selling.

"There has been so much unwinding of risk," he said. "As you unwind that, the price of convertibles goes down versus equities."

There is also supply. Unlisted German state bank Kfw KFW.UL issued a 3 billion euro bond on Tuesday, converting to its holding in Deutsche Telekom (DTEGn.DE) shares.

But the main drive is an assumption that volatility will return for a while without dislodging an overall recovery -- and therein lies the risk.

While convertibles will outperform equities in times of volatility, they don't do as well if stock markets are gaining steadily: straight equities would then be a better bet. Similarly, a long recessionary period would make other fixed income more attractive and could put corporate debt in general under pressure.

What is needed for convertibles, according to Olivia Mayell, a client portfolio manager with JPMorgan Asset Management, is a period of "cautious optimism".

Hence investors' current interest.

(Additional reporting by Richard Barley; Editing by Ruth Pitchford)