Cautious optimism converts investors to convertible

By Jeremy Gaunt - Analysis

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.

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