Key Factors Driving Convertible Bond Redemptions

The convertible bond market has recently witnessed a resurgence in activity, driven primarily by a striking phenomenon known as strong redemption densityFor individual investors, the combination of small-cap stocks and low premiums is turning into a potent factor for investment opportunitiesInterestingly, it's less about the institutions not wanting to use these strategies; rather, they find themselves unable to maximize their potential in this niche market.

From mid-October to early December, a total of 22 convertible bonds were redeemed and another 15 had announcements of impending strong redemptionsAs the market progresses through this cycle, convertible bonds across various types have reached their redemption limits, suggesting a multitude of paths available for investors seeking to navigate this new terrain

However, it’s essential to recognize the distinct risks, returns, and efficiencies associated with different strategies for convertible bondsThere are significant distinctions between the types of strategies suited for institutional versus individual investors.

In light of recent market trends and shifts between bullish and bearish phases, it becomes imperative to analyze the convertible bond investment strategies that have emerged, along with their pertinent differences.

Examining the Market Through Strong Redemption Density

Investment strategies hinge upon differentiated market conditionsBefore diving into current strategies and applicable factors for convertible bonds, it’s crucial to assess the overarching market landscape.

Convertible bonds have certain generalized valuation metrics that are widely accepted within the market

• The Fall of German Auto Giants
• The Three Phases of Cheetah Mobile
• Satellite Industry Enters Commercialization Era
• Treasury Yields Rise Amid Asset Scarcity
• Maintaining Cost-Effectiveness in Public Bonds

Thanks to an extensive sample size of convertible bonds, metrics such as median levels, median premium levels, parity levels, and average yield to maturity are effective for valuation assessmentsHowever, these metrics can fall short when evaluating the strength of market trends or determining the current bullish or bearish market stateIndeed, valuations can remain underestimated or overestimated post-adjustmentsThe authentication of market conditions can, instead, be sourced from strong redemption dataThis is based on the inherent design characteristics of convertible bonds and the belief that redemption density directly correlates with market strength.

Historical data underscores this phenomenon: after the expansion of convertible bonds in the fourth quarter of 2017, only two redemptions occurred in 2018, which was, notably, a bear market for equities

However, the following year witnessed a bull market where 21 convertible bonds redeemed throughout the year—an increase of tenfold in redemptionsThe positive trend continued in 2020 with 71 redemptionsFast forward to 2021, when the equity market began to diverge, small-cap stocks thrived, resulting in another year of bullish behavior with 73 redemptionsUnfortunately, the numbers fell to 52 in 2022 and further plummeted to 42 in 2023. Yet, by October of that year, redemption activity surged again, with 22 new redemptions surfacing in just two months, emphasizing the intimate connection between redemption density and convertible bond market strength.

Currently, the overall valuation levels of convertible bonds seem not to be overstatedA notable example can be drawn from the median data for convertible bonds, showing that their premium rates remained below the 50th percentile since 2017. The underlying factors are rooted in three years of lackluster performance and a crumbling belief in the convertible bond market prior to 2024, where the market sentiment and valuations still lag significantly behind peak periods in late 2021 and early 2015. Nevertheless, the evolving redemption data, coupled with insights from market operators and policies, indicates that substantial opportunities lie ahead for convertible bond investors.

The Beloved Double Low Strategy

Convertible bonds are traditionally viewed as lower-risk investment products

However, thanks to the unique options derivatives, they can be combined to align with various risk appetites among investorsThe ultimate strategy for investors is undoubtedly one that promises "low risk and high returns." While this may seem paradoxical over the long term, convertible bonds can fulfill the emotional investments of lower-risk seekers, aligning with their needs due to their multifunctional nature—both offensive and defensiveThe "double low" strategy has emerged as a prominent and straightforward tactic for investors, so much so that numerous financial platforms and sell-side reports still utilize this "double low" categorization.

In simplified terms, the double low strategy merges the factors of low price and low premiumWithin the multitude of market dynamics affecting convertible bonds, a low price signifies security and bond-like returns (prior to the first default in 2023), while a low premium indicates that the convertible bond will theoretically rise in step with the underlying stock

While these factors may appear contradictory, prevailing market dynamics and expanding sample sizes lead to the emergence of a combination that embodies both "safety and aggressiveness." Prior to 2023, the historical default rate for convertible bonds stood at zero, alongside particular downward adjustment clauses in the bonds, meaning that lower-priced convertible bonds were typically insulated from declines in the underlying stockMoreover, their low premium attribute enables these bonds to exhibit explosive upward momentum during recoveries of underlying stocks after major declines.

The period from 2017 to 2023 generated remarkable performance from these strategies, yielding impressive gains while facing minimal pullbacksThe reason the double low strategy wasn't highlighted before 2017 can be traced back to the insufficient number of examples and rare existence of long-term combinations of low-priced and low-premium convertible bonds at that time

Nevertheless, after notorious defaults occurred on specific bonds in 2023, this strategy began to falterIn the aftermath of those defaults, many lower-priced convertible bonds faced significant declines, leading investors to realize that "everything comes with a price."

On a micro level, most market conditions are typically effective, yet investor emotions often remain erratic and driven by inertiaThe market frequently presents rationalityBefore the emergence of catastrophic defaults, lower-priced convertible bonds also faced downward pressures due to financial deficiencies and default anticipations, which consequently held their premium rates downThe distinct presence of a "convertible bond faith" contributed to the stabilization of stakeholder sentiment, managing to keep actual pullbacks and risks within controlThe prevailing notion was that the market can always reverse after enduring dark periods; convertible bonds could often adjust downward on conversion prices, restoring lower-priced bonds back to stability—a mentality encapsulated by "bad stocks, good convertible bonds." However, the onset of actual defaults in 2023 shattered the faith of convertible bond investors, evoking widespread panic among low-priced bondholders, creating a crushing blow against these previously favored investments

The double low strategy suddenly transformed from a proven method to a high-risk gamble during this turbulent phase.

Iteration of Double Low: Integrating Small-Cap Factors

After the "924 event," where the stock market experienced massive gains across both volume and price, sentiment to go long intensifiedThe frequency of strong redemptions among convertible bonds surged, invigorating expectations surrounding stock conversions, while concerns surrounding “face-value delistings” diminished, thus revitalizing interest in convertible bonds within the marketplace.

For regular investors looking to sieve through public information or data to pick bonds (factor selection), it's vital to grasp the array of integral elements of convertible bonds and their meanings

Following this understanding, one may then proceed to form combinations that accurately simulate or practically evaluate the associated risks and rewardsFor instance, the previously successful double low strategy combined safety-focused factors with those directed at returnsBefore systemic defaults were observed, the safety focus worked effectively alongside continuously valid yield-generating factorsOther critical factors must include: remaining size, underlying stock dynamics, stock dilution ratios, trading activity (volume and price surges), time till maturity, and any adjustments applicable.

Taking cues from the evolving structure of the stock market, the outperformance of small-cap indices provides clear insights: ordinary investors should place emphasis on the scale factors pertaining to convertible bondsObservationally, smaller-cap convertible bonds often display bottom-tick support, leading to increases, while simultaneously being more resilient against declines, frequently experiencing surges with heightened volatility

The logic underlying this trend reflects the attraction of capital to structural opportunities within small-cap convertible bonds, given the observable profit effects seen in small-cap stocksWith more funds focusing on these opportunities, naturally, the pricing elevates.

So how can one acquire inexpensive small-cap convertible bonds? The essence of "cheap" bonds in this context arises from a blend of two elements: valuation and relative pricingValuation reflects low premium factorsLow premiums confer dual benefits, facilitating the bond's ability to rise in line with its underlying stock while steering clear of volatile investment fadsIdeally, these prices must not only be cheap but reasonably soGiven that markets are typically efficient, any existing pricing often bears latent or manifest risksTherefore, the focus should shift to finding small-cap convertible bond combinations that are reasonably priced and boast low premiums, allowing these bonds to fully leverage their characteristic of being "offensively, defensively useful."

Dialectics of Adjusting Factors

Convertible bonds possess a unique characteristic in their ability to be adjusted downward—a distinct phenomenon that often parallels a bug in the system

The various strategies arising around adjusting conversion prices have prompted a heated battlefield of tactical approachesParticularly in the context of an elongated bear market, as well as the expansion of the convertible bond sample pool, the call for adjustment and subsequent price modifications has become recurrentOverall, downward adjustments are favorable for bondholders, amplifying the value of their underlying stocks to a significant extentWhen a convertible bond’s conversion price drops, its respective share entitlement value increases, allowing bondholders to secure potentially substantial equity returns as stock prices rebound.

However, it is vital to acknowledge the nuanced challenges that accompany heightened adjustment ratesInvestors must adopt a critical lens when assessing the ratio of convertible bond dilution to the circulating market capitalization of the underlying stocks

Convertible shares, once converted, can circulate freely on the trading day following the transactionFor instance, if a convertible starts with a share equivalency of 50% of the circulating stocks, a 50% downward adjustment could elevate the dilution ratio to 100%, significantly affecting equity pricesSuch high dilution conditions tend to exert downward pressures on the underlying stock price, leading to critical considerations during individual stock trading or promotional effortsMoreover, considerable downward adjustments might signify distress for the issuer, while frequent price adjustments could point to a weakening ability to address bond debts—concepts that investors must critically evaluateNotably, several past incidences of convertible bonds encountering severe defaults often exhibited patterns of frequent and extreme downward adjustments.

After a significant downward adjustment, there's a pronounced likelihood that issuers will opt to exercise their strong redemption rights

The rationale is rather straightforward: issuing entities would not relinquish the opportunity for strong redemption lightly, especially when facing substantial dilution consequences as a trade-off.

Ultimately, while the impacts of adjustments remain limited, investors ought to proceed with caution and remain attentive to such conditionsFor convertible bonds with notable proportions of adjustments, ordinary investors should blend insights from macro market trends, industry dynamics, and the underlying stock's fundamentals for informed decision-making, aiming to maximize on adjustment gains while sidestepping potential pitfalls.

Retail Bonds Versus Institutional Bonds

In the realm of convertible bonds, retail investors have the potential to outmaneuver institutional investors, primarily attributable to differences in investment behavior and the specific characteristics of convertible bonds

Institutional purchases tend to favor liquidity and large-cap bonds, which leads them to avoid small-cap varieties and instead cluster around big-cap bondsThe volatility, intraday elasticity, and overall price shifts of large-cap bonds typically contrast starkly with smaller capitalized counterpartsThis trend is evident in the stock market; post "924 event," the small-cap indices and the North Exchange 50 index demonstrated overwhelming performance, primarily due to the scarcity of larger institutional and public funds committed to small-cap stocks—creating a unique battleground for price recovery.

This parallel holds true in the convertible bond market as well; in active market scenarios, smaller-cap convertible bonds are best approached with caution against institutional investment stylesThis can be cross-verified through an analysis of the performance discrepancies among the top three convertible bond indices, where the weights of institutional bonds in the CSI Convertible Bond Index dominate comprehensively over others.

Despite the efficacy of small-cap factors, the question arises: why are institutions reluctant to utilize these bonds? This boils down to a matter of capacity rather than desire