Japanese Convertible Bonds and Their Use by Small Cap Fund Managers

The Japanese convertible bond markets offer small and medium cap equity portfolio managers many opportunities to enhance their risk/reward profiles. Neale Safaty, a 17-year veteran of Japan's financial markets and currently a portfolio manager at KBC Alternative Investment Management U.K. Limited, reviews this much overlooked asset class.

A convertible bond (CB) is a security that is normally issued by a company and exchangeable at the option of the holder into equity. It is a hybrid security that combines a fixed income element and an embedded equity call option. At issue, it normally displays a balance of equity and bond. The underlying share price relative to the conversion price (the price at which a convertible can be exchanged for shares) determines the intrinsic value, or the equity value of the convertible. The credit rating, credit spread, and general level of interest rates determine the bond floor, or where it would trade if it were a straight bond. When the share price rises and the convertible is in-the-money, the convertible exhibits equity-like characteristics. As the share price falls relative to the conversion price, the convertible becomes less equity-sensitive and behaves more like a straight bond. Deep in-the-money convertibles are almost pure equity substitutes, as they have minimal downside protection. Deep out-of-the money convertibles, however, are almost pure bond substitutes, as the embedded equity call option is practically worthless.

In the event of a company filing for bankruptcy, convertible bond holders rank higher than ordinary shareholders. Japan suffered her highest profile bankruptcy in 1997 when Yamaichi Securities went under. It is interesting to note that all of Yamaichi Securities' CBs were eventually paid out in full, at par. In short, they are less risky than stocks, and numerous research studies have proven that they offer good returns with moderate risks. Ibbotson, a Chicago-based research consultancy, produced a paper in the summer of 2001 that concluded that Japanese portfolios that included CBs as a distinct asset class were more efficient. Despite this evidence, a relatively common view among equity managers is that CBs are "derivatives" and thus non-eligible securities. This is at best lethargy, at worst negligence.

Japan has a mature convertible bond market. It was formally established in 1966 when Nippon Express issued a CB of 10 years' maturity. However, the product did not come of age until the 1980s, when the booming Japanese economy and stock market helped create the world's largest convertible bond market. It reached a market cap peak of $180 billion in the '90s. Today, it is ranked number three (behind the US and Europe) with a capitalization of $109 billion.
Convertibles appeal to a broad range of investors with different risk profiles and investment criteria, including equity funds, dedicated convertible funds, hedge fund managers, and fixed-income investors. Traditional Japanese long-only equity portfolio managers have historically used convertibles when they are an attractive alternative to stock. In principle, they invest in CBs that offer both upside performance similar to the equity and downside protection should the underlying share decline. In difficult market environments -- not that rare in Japan in the last decade -- equity portfolio managers use CBs as a defensive strategy to smooth out portfolio volatility. In the small and medium cap arena, equity managers can find a significant number of CBs that offer a better risk/reward profile than the underlying stock and, in many cases, better liquidity.

The market can be divided into two distinct categories: yen-denominated domestic issues that are listed on the domestic stock exchanges and predominantly sold to Japanese investors, and Euro-convertibles that are underwritten by foreign securities firms and investment banks and distributed to overseas investors. Both groups share many common characteristics, although there are a number of distinguishing features, such as the market place, regulatory environment, liquidity, the transaction mechanism, and the investor base. The vast majority of the outstanding universe are domestic securities, comprising over 88% of issuance capitalized at $110.4 billion. The domestic market is regulated by the Japanese authorities and most business is transacted through the Tokyo Stock Exchange. Orders are executed on a matched buyer and seller basis with a high degree of transparency, the same mechanism used for stocks. Given this somewhat restrictive transaction mechanism, only 10% of outstanding issues trade in excess of JPY50 million nominal on an average day. 

The Euro-convertible market is a completely different animal. It is considerably smaller in terms of market capitalization and the number of issues, and less structurally homogenous than the domestic market. The majority of convertibles are held within convertible bond funds, hedge funds, and equity portfolios. The Euro-market is broken down into two main currencies: Euro-Yen and Swiss Francs.

The trading mechanism in the Euro-convertible market is very different from the domestic convertible market. International banks and securities firms make two-way quotes to both clients and each other (the professional market). This practice gives clients access to instant liquidity. Should an investor wish to buy a security, a market-maker need not necessarily have an existing position to facilitate the customer. However, in Japan an investor can only purchase a domestic convertible if there is a matched seller. Moreover, if an investor inadvertently oversells or shorts a domestic convertible, then the exchange can impose extremely punitive measures for non-delivery. Buy-ins can be very expensive on exchange-traded securities, whereas there is a greater degree of leniency in the largely self-regulated Euro-market.

Japanese companies that have issued Euro-convertibles range significantly in terms of size. The majority of corporations that have issued Swiss Franc convertibles are small and medium capitalization companies whose shares are either listed on the second section of the Japanese exchanges or are registered on the OTC market. Because of these differences in the size and profile of the market's borrowers, the overall credit quality of Euro-convertible issuers is considerably lower than in the domestic market. A large percentage of the issues are rated below investment grade or not rated at all. All Swiss Franc issues are private placements and are therefore not listed on exchanges, whereas most Euro-Yen issues are listed on European exchanges. The cost of issuing a private placement is comparatively lower, which partially explains why smaller companies may prefer to use this route. Equity investors should always check with the their trustees or investment guidelines to determine whether they can purchase non-listed securities.

The Euro-bond market has a tradition of being innovative in terms of structures that accommodate both borrowers' and investors' needs. The Japanese Euro-convertible market is no exception. Since the late 1980s, a significant proportion of Japanese equity-linked securities (including warrants) have been issued with additional layers of downside protection. For example, if the underlying share price falls during a specified time period, there are provisions for the conversion price to be adjusted downward by as much as 35% in some cases. 41% of the 126 outstanding Euro-convertible issues include these downward refix clauses. In addition, 37% of Euro issues have put options, which allow the bondholder to put the convertible back to the company at a specific price on a specified date. These features have provided investors with a double dose of protection. Given the increased uncertainty and volatility in the Japanese stock market, small and medium cap equity fund managers can certainly find attractive stock alternatives in Sega, Nichiei, Venture Link, and Parco, to name but a few. ii