Convertible Bonds: Is the Investment Logic Still Valid?

Let's start with the conclusion: Still present.

The convertible bond equal-weight index on Jisilu has dropped from 1968.065 at the end of 2023 to 1745.459 as of this Friday's close, a decrease of 11.31%. This means that most convertible bond investors have incurred a loss of about 11% this year. Such widespread losses have led many investors to question the investment logic of convertible bonds, which is a natural human reaction.

However, let's return to the intrinsic value of convertible bonds and we will find that the investment logic based on a solid foundation remains stable. It's just that the investment logic of castles in the air is as elusive as the wind, appearing and disappearing, difficult to grasp.

The concepts of "solid foundation" and "castles in the air" come from "A Random Walk Down Wall Street."

The term "solid foundation" implies that the value of an investment is the basis of its price. Because of this foundation, the price will not fall indefinitely, and of course, it will not rise indefinitely either.

On the other hand, "castles in the air" means that the price of an investment depends on the price the next buyer is willing to pay. If the buyer believes that there will be someone else who will pay a higher price later, then even if the current purchase price is far higher than the value, it is not a problem.

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Let's talk about the solid foundation of convertible bonds first:

1. Repayment at maturity (or repurchase before maturity)

In the absence of default, repayment at maturity is inevitable. Different convertible bonds have different maturity prices, most of which are around 110 yuan. This means that by holding until maturity, one can receive the principal and interest. Therefore, if one purchases convertible bonds with a positive after-tax yield to maturity, at least one can earn the money from the maturity return.In the case of a buyback, it is usually 100 yuan plus the current interest. For example, the recent buyback of Kehua Convertible Bonds had a buyback price of 100.185, and after deducting the interest tax, one can receive 100.148 yuan. For Kehua Convertible Bonds (SZ128124), if the purchase price is lower than 100.148, then money can be made. Of course, on Friday, Kehua Convertible Bonds hit the upper limit, and that's a story of a castle in the air, which will be discussed in the following paragraphs.

Recently, there have also been buybacks of Monalisa Convertible Bonds (SZ127044) and Changji Convertible Bonds (SZ128105). The former's lowest price in July fell to 82.188, and the latter's lowest in August fell to 94.846. Even if one cannot buy at the lowest point, it is still possible to purchase at a price below 100 yuan.

There are many similar convertible bonds. Convertible bonds will not default on a large scale, and even if they do, a portion will be partially redeemed in small amounts, such as Lingnan Convertible Bonds. The financial situation is already very poor, and in the end, the part within 1000 pieces was redeemed at 100.127 yuan per piece, and previously, there were also Quanzhu Convertible Bonds and Zhengbang Convertible Bonds that were partially redeemed in small amounts. From memory, the ones that might ultimately not receive money seem to be only Sout Convertible Bonds, Blue Shield Convertible Bonds, and Hongda Convertible Bonds.

For these three, if one can spend a little time looking at the balance sheet, they can be avoided. Even if they are not discovered at the time of purchase, there are still opportunities to sell at 80, 90, or even 100 yuan when the problems are exposed.

Even if all three are hit, if there are 30 convertible bonds in the portfolio, and these three account for a total of 10%, and if they are all bought at 100 yuan and sold at 70 yuan, it will only cause a 3% loss to the entire portfolio.

Therefore, the logic of making a profit still exists when buying convertible bonds with a positive maturity return, or even more conservatively, buying convertible bonds near or below par value.

2. Forced Redemption

This is the outcome that most companies issuing convertible bonds hope for. If you buy and hold until forced redemption with a positive maturity return, if you sell at a price of 130 yuan, then the return rate is approximately 20%. If you buy and hold at par value until forced redemption, the return rate is at least about 30%.

Of course, the solidity of this value is slightly weaker. In the past, the vast majority of convertible bonds ended with forced redemption, and recently, there have been more buybacks. This is not because there is a problem with the logic of convertible bonds, but because the stock prices are too low. Stocks only have a chance of forced redemption when they rise; if stocks keep falling, even if they are adjusted down, they cannot touch the forced redemption line.

If these stocks rise again in the next few years, there will be more forced redemptions. Now, many people may think that these stocks will be difficult to rise in the future, just as they thought they would not fall a few years ago. These are all biases caused by the "recency effect."3 The Value of Options Brought by Fluctuations

This profit logic is somewhat similar to forced redemption. It usually involves buying convertible bonds that are close to maturity and have a very low probability of default, near the expiration price. If they expire, there is no loss or a slight loss; if they rise by a certain amount before expiration, they can be sold for a profit.

For example, take CITIC convertible bonds, which have less than half a year to maturity and an expiration price of 111. If they are bought at a price of 111.x recently, and if the stock price does not rise, they can be sold at a price of approximately 110.8 on the last day before expiration, resulting in a loss of a few cents per bond. However, if the price rises before expiration, they can be sold for a profit.

4 Discount Arbitrage/Liquidation Arbitrage, search for this on your own, there is nothing much to say, skip.

Let's talk about the Castles in the Air

Based on the investment logic of castles in the air, it is also possible to make money, but the difficulty of making money is much higher than with a solid foundation. The vast majority of people who follow this investment logic will eventually lose money, and only a few experts and the lucky ones can make money.

1 Low Premium

The main logic of this strategy is the stock-bond linkage. When the market rises, convertible bonds often increase more than the underlying stock, and when the market falls, convertible bonds often decrease less than the underlying stock. Based on this logic, one should select convertible bonds with topical underlying stocks for purchase, waiting for the underlying stock to be hyped up to drive the convertible bond's rise or for the convertible bond to be hyped up and then sold for a profit.

Convertible bonds with this characteristic are usually not too cheap, with most prices above 110 yuan, even reaching 120 yuan or 130 yuan.

This strategy had good returns in previous years when small-cap stocks were active, but with the general decline of small-cap stocks this year, the choice of targets is crucial, and the investment difficulty is very high.2 Betting on Downward Adjustment of Conversion Price

The main logic of this strategy is to estimate, based on existing information, that the company will soon announce a downward adjustment of the conversion price, and to buy convertible bonds to sell them for profit after the adjustment is announced. This method involves significant uncertainty, such as whether the company will adjust the price, by how much, and how much the convertible bonds will rise after the adjustment. It demands a high level of skill from investors, and most participants find it difficult to profit.

3 Betting on Speculation of Small-Scale Convertible Bonds

For example, the Tianchuang convertible bond previously experienced a rapid increase from around 100 before the buyback declaration to over 200 within a few trading days after the declaration ended, due to its small remaining scale. The price has remained above 200 since then. Such valueless price increases are akin to castles in the air. Similarly, the Kehua convertible bond on Friday this week also reached a 20CM limit-up on the trading day following the declaration's end.

Of course, not every convertible bond behaves this way. For instance, the Fuchun convertible bond, which was bought back a few days after Tianchuang, fell after the buyback.

For convertible bond investors based on solid fundamentals, the loss this year should be less than the decline of the equal-weight index. For those based on castles in the air, it depends on individual ability and luck.

For investors based on solid fundamentals, now is actually a good opportunity for screening and buying.