With your host Hank Cunningham
Harry Koza's Weekly Column
December 8, 2006
The conversation continues
TORONTO (GlobeinvestorGOLD) - ?Harry, you're starting to scare me," said the Canada trader.
"I mean, you write a column on something I never heard of ? like CPDOs (constant proportion debt obligations) last week ? and a few days later, there's Bill Gross, the king of bonds, talking about the same thing on the Pimco website" (www.pimco.com).
"Let me guess ? he thinks they're insane, too?"
"Well, in his tactful way, he says that ?leverage, at least as applied to this particular area, appears to have run out of its magical ability to increase returns,' which is about as close as he'd ever get to saying they are freakin' crazy and anybody who buys one ought to have his head read. Anyway, you've done this a couple times now, like when you wrote that column on the Doomsday Call and a week later someone exercised one. You're uncanny, dude."
"Yeah, well, even a broken clock is right twice a day. Now, you were going to tell me about those crack-house bonds, but I read the article about them in the Globe last week. Very bizarre."
"And you were going to tell me about reverse convertibles."
"Okay, they're pretty bizarre, too. And, as I said before, the proliferation of strange new financial instruments ..."
"Yeah, yeah, is one of the most reliable indicators of a market bubble. You got bubbles on the brain, dude."
"Maybe so. Let me tell you where I first got that notion about outr? investment instruments being a harbinger of a bubble's imminent bursting. You won't recall the Milken junk bond era, since you were likely in the sixth grade at the time, but just before it all went pear-shaped and they put Mike Milken in jail and made him pay a half-billion dollar fine, his shop ? Drexel Burnham Lambert ? came up with the ultimate in financial engineering: bonds backed by the air rights over Manhattan office buildings. I mean, you?ve got to hand it to them, securitizing air ? it demonstrates remarkable chutzpah. But the really scary thing was that there were punters out there who were willing to buy them."
"Air bonds. Man, that's almost as cool as junior subordinated zero-coupon perpetuals."
(Note: If there was such a thing as zero-coupon perps, they'd never pay any interest and they'd never pay back the principal, either. They were first proposed satirically by James Grant, as the ultimate levered buyout financing tool.)
"If anybody ever issues one of those, you'll know the world is about to end. Okay, reverse convertibles. They're like a regular convertible bond in that you get a coupon and the principal is convertible into shares, so you get exposure to both the stock and bond markets without having to actually buy both types of product. With a regular convertible, you can choose to convert to stock when the shares are worth more than the conversion price. But with a reverse convertible, the issuer gets to pay you off at maturity in shares instead of cash, at his option, not yours, and he's only likely to do that if they are seriously underwater.
"They are usually issued by big banks, so the bond is the bank's own debt, but is convertible into some other company's shares ? preferably some blue chip. It's basically a bond with an embedded put option on the underlying shares."
"So the bank is short the bond and long an option to pay it off with a certain number of shares."
"Exactly. If the stock tanks and the bond market goes up (interest rates go down), the bank exercises its option, unloads the shares on the investor to pay off the note and issues new debt at a much lower coupon."
"So the only way the buyer wins is if the bank doesn't exercise its option, interest rates stay the same, and the stock doesn't go down. If the stock price drops, the fat coupon may not be enough to offset the losses, plus, if it all turns to crap, they pay you back in crap? That's brilliant! I wish I'd thought of that one."
"Barclays Bank did one recently with GM shares as the underlying, and it has a 16-per-cent coupon. If GM shares drop 20 per cent or more during the life of the note, you get paid off in GM shares." [post-publication note: GM shares are up huge since this one was issued, however]
"Hang on a minute, Harry. You should be able to hedge a reverse convertible by buying some downside protection on a major stock index, and, in theory at least, increase your portfolio's exposure to riskier, hopefully higher-return, assets without incurring any extra risk."
"Wow! You must have just written the CFA [chartered financial analyst] exam."
"Level Three, dude, I'm a finance ninja now."
"You're right. For sophisticated investors using proper hedging strategies, there's probably a role for reverse converts. The thing that makes me leery of them, though, is that they are increasingly popular, especially in Europe, where they are mainly sold to retail investors."
"Who, naturally enough, only see the fat coupon and not the risk."
"Um, it'll end in tears?"
"Just like running with scissors. I'll make a bubbleologist out of you yet."
Sr. Market Analyst,
36 Green Meadow Crescent,
Richmond Hill, Ontario,