Tuesday, January 20, 2015

This article appeared in The Edge on Nov 17th, 2014

Negative yield in bonds
In September this year, Khazanah Nasional Berhad issued a USD500 million exchangeable sukuk, the third of its kind within the last two years. What is interesting about these sukuks are that they were zero coupon sukuks with negative yields.  
Negative yield in bonds are not common in the market, but it may become more frequent. In this article I define negative yield and show how it is computed. The motivation of investors to invest in such bonds is explored. Finally the article discusses the mechanics of convertible and exchangeable bonds.
Understanding negative yield to maturity
When an investor buys a coupon-paying bond, he is promised a series of regular coupons and the
redemption of principal at the end of the bond tenor. If he buys a zero coupon bond, he does not get any coupon during the tenor of the bond, instead he receives a higher redemption at maturity. The return earned by the investor is called the yield.
The most appropriate type of yield in the fixed income market is the “yield to maturity” (YTM), which can be interpreted as the yield earned by the bond investor assuming he holds the bond until maturity.
This yield represents the flat discount rate that will value the future cash flow from the bonds (coupons and redemption of principal) at its price today (present value). In Figure 1, a 5% coupon fixed bond maturing in 4 years time is trading above par, at $102 today. The ‘r’ in the equation is the YTM. Solving through iteration, we find that the YTM is a positive 4.44%. The YTM is so widely used that in the fixed income market, that it is common to quote the YTM of the bond instead of its price.
Figure 1: Solving for ‘r’ gives the yield to maturity (YTM)
Now, if a bond was trading at a much higher price, say at $120.23, the implied ‘r’ or YTM would turn negative to -0.05%. An investor would have bought the bond for $120.23, receiving yearly $5 coupons and a redemption of $100 at maturity. Accounting for time value of money, he is receiving less than what he invested in, hence the ‘negative’ yield.
Why would an investor invest in negative yield bonds
Lately, Germany has been issuing 2-year bonds at negative yields. The rationale here could be that given the present uncertainty in the European economy, local investors are looking so hard to keep their money safe, that they are willing to pay for it.
For some time, some money market instruments like CDs (Certificates of Deposits) in Denmark were yielding negative rates of around -0.2%. Reports claim that the central banks of Denmark have had so much money flowing into the country that they had to make the currency unattractive by offering negative yields.
Negative yield does not necessarily have to stay negative during the life on the bond. If the price of the bond drops, the yield will rise and could even turn positive.
Negative yield in convertible and exchangeable bonds
A convertible bond comes with a conversion feature that gives the investor the option to convert the bond at a certain conversion premium, into shares of the issuer company after a stipulated period. For example a 7-year convertible bond with a 15% conversion premium can be converted into shares once the shares move up by 15% from its reference share price (determined at the date of the bond issue). If the reference share price was $4 and during the conversion period the price goes up above $4.60, an investor with an exposure of $50,000 nominal worth of bonds could choose to convert his bonds into 10,870 shares in the issuer company. If the price of the shares at that time was $5, he can sell the shares and make a $4,348 profit [10,870 * ( $5 - $4.60 ) ]
Exchangeable bonds have similar characteristics to convertibles, except that the bonds can be converted into shares other than of the issuer company. Usually the shares belong to a company that the issuer already owns and plans to divest its stake.
The potential to make a capital gain is so attractive that it is a quite standard for investors to forego some yield and accept a lower coupon rate on the convertible. Stretching this further, if the potential upside for the share is so promising, the convertible will be highly sought after, convincing investors to invest in the bond even with a negative yield. In 2006, Resorts World sold a MYR1.1 billion zero coupon 2-year convertible bond at a negative yield that redeems at 99%. The yield for this would be -0.5%. [For zero coupon bonds, we just discount the redemption amount over 2 years [ $100 (par at issue date) = 99/(1-0.5%)2].
Recently Khazanah has successfully launched a few zero coupon exchangeable bonds at negative yields. The most recent one in September was a USD500 million zero coupon sukuk exchangeable into shares of Tenaga Nasional Berhad (TNB). The sukuk had a maturity of 7 years accompanied with a put option at the 4th year for investors to sell back the bond to the issuer. The exchange premium was at 15%. The bond was reported to have a negative yield of -0.05%. Assuming the bond was priced up to the 4th year (where the put could be exercised), and the bond was issued at par, the redemption at Year 4 would be approximately 99.8%.
Mechanics of convertibles and exchangeables
It is worth knowing that investors in convertibles and exchangeables are not the common buy & hold investors but rather global investors who are convertible bond specialists. They often do convertible arbitrage activities with several strategies to take advantage on the mispricing in convertible bond prices. These specialists also act as dealers who often split the convertible into two components, to trade with different kinds of investors.
Chart 1

As shown in Chart 1, the first component is called the callable asset swap (a fixed income component) and the second, the convertible bond option (CBO) (an equity component).
The dealer enters into these two opposite transactions with the fixed Income and equity investor. Fixed income investors, like money market funds and insurance funds do not want to assume the equity risk on the bond. Whereas equity investors are only interested in equity risk and do not want exposure on credit risk.
The equity investors who already bought the convertible bond will sell the bond to the dealer and simultaneously buy an option to repurchase the bond at a strike price. This feature enables the equity investor to buy back the convertible when it is attractive for converting, and convert the bonds into shares (as he is only interested in the equity part).
The dealer will then sell the Convertible to the Fixed Income Investor and simultaneously buy an option to buy back the bond. The dealer will exercise this option when and if the equity investor calls on the bond.  The Fixed Income Investor will also enter into an interest rate swap with the dealer to swap the fixed interest rates into floating rates (LIBOR) plus the credit spread of the issuer. Effectively the Fixed Income investor synthetically transformed his fixed coupon convertible bond into a callable floating rate note. The deal will be structured such to enable the investor to gain a better return than if he was holding the convertible itself.
Without going into detailed numbers, the dealer will negotiate the credit spread with the fixed income investor and negotiate the value of the convertible bond option (which hinges on volatility of the underlying shares) with the equity investors. In practice, these negotiations will start even before the convertible bond is issued so that the issuer can set the right conversion premium and coupon rate to ensure the bond is marketable. Vigorous computations will take place around the credit spread, the interest rate swap value, the CBO option and the volatility of the share in order to balance the amounts on both sides for the dealer and at the same time achieve the issuer’s required proceeds. At times, this can be challenging; for example if the issuer is unwilling to pay much coupons, the interest rate swap must have a low-ish credit spread, if not the CBO option will need to be priced at a very high volatility, which may not be represented by the historical volatility of the shares.
Conclusion

As long as interest rates for the USD and EUR remain extremely low, negative yield in short term government bonds are likely to become more common. Convertibles and exchangeable bonds will be able to join this trend as long as they are issued by creditworthy issuers and demand is fuelled by investors scrambling for yield.

4 comments:

  1. It's great post! Thanks for sharing!

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