Tangible Market Inefficiencies in Convertible Bonds

If one thing this financial crisis has exposed, it is that markets aren't as efficiently priced as half of modern financial theory presupposes. I am not referring to the housing crisis, where much has already been said. Rather, I am referring to stock, bond, and derivative markets for a wide range of companies. Market dislocation has resulted in some peculiar inefficiencies crossing this Stalwart's eye, some of which are very tangible.

For stocks alone, its always pretty hard to reject efficiency in pricing since there are a lot of fuzzy variables. But when you look across the capital structure of a single company and compare prices for different securities related to the same underlying stock, this is where the recent market dislocations have exposed clear ineffiencies in my opinion.

One example this Stalwart has seen has been an issue of convertible bonds, with equal seniority and credit rating to plain vanilla bonds for the same company, providing higher yields to maturity than their plain vanilla bond relatives. They also had shorter maturities, plus provided an option (though far out of the money due to the underlying stock's collapse) as an added bonus as well.

Why the yield difference? Well it has at least been proposed that a lot of convertible bond funds have ceased to exist or reduced their activity due to their previous reliance on leverage, thus removing a lot of buyers. And standard bond funds usually won't buy converts as a matter of investment mandate.

A second example has been again a small issue of a convertible bond, but one right near-the-money with its conversion price vs. the current stock price. This means it's almost the same as buying the stock. The kicker was that the bond was puttable at par two years forward, with a slightly negative yield to put. The company was net cash and a well established leader in what it does, thus payback of the bond within two years is highly certain, if not nearly absolute.

This basically means that the risk reward was equal to the stock on the upside, but with only a slight negative loss should the stock fall and investors are forced to put the bonds (easily done by the net cash company).

Some stocks have also become compelling vs. their related options, as option premiums for some stocks hit substantial percentages of their underlying, making their downside risk profile (losing your premium) quite similar to simply buying the stock. And vice versa.

I'm in no way saying things are easy, all situations carry risks, some of which are hard to gauge. But at the very least there are securities out there which appear clearly better or worse plays on the same underlying. And market dislocations and panic have made this more apparent than perhaps in the recent past.