Hedging the election

13 April 2010

Elections have been known to move markets quite sharply in certain circumstances. The problem is that surprises are often dished out by the electorate, so the movement can sometimes potentially be sharp in either direction.

The classic example was in 1992, when the narrow Conservative victory was against most expectations.
As thing stand at present, a narrow outcome in either direction looks possible. So it's worthwhile examining ways in which you can, in the first instance go some way to protecting your investments and secondly, capitalise on the opportunities that arise from these events.
There are two natural ways in which investors can make an each way bet on the markets. Both make use of options, either directly or implicitly.

One is using an option strategy known as a 'straddle' or a 'strangle', which I will cover in part two. The other is using convertibles, which is what I plan to look at this time round.
A convertible is a bond or preference share that pays a fixed amount of interest or dividend but which also confers the right, but not the obligation, to convert into ordinary shares on fixed terms and at specified dates.
The practical effect of this is that, if the shares stay the same or fall, the convertible becomes, to all intents and purposes, a fixed-income investment.

If the shares rise, particularly if they rise substantially, the conversion feature becomes much more valuable and the price of the convertible rises accordingly. The rise is unlikely, however, to be as sharp in percentage terms as the rise on the ordinary shares.
Though convertibles are safer than ordinary shares, they are not totally insulated from market movements or from corporate problems. Convertible preference shares, for example rank ahead of ordinary shares in the event of liquidation, but only just.

They rank behind everything else. Preference shares also often have dividends that roll up if payments are missed. So there is more protection against default.
In the case of convertible bonds, security is greater than for preference shares but often less than for other forms of debt. Convertible bonds are frequently issued as unsecured loan stock, so no corporate assets are attached to them that could be sold in the event of default.
The problem with convertibles is that of late there have only been a relatively small number in existence that are readily accessible to private investors. Investment trusts used to be big issuers of convertibles, but this is no longer the case. Those that are left are very illiquid.

Since corporate bond are now more easily dealt in through private client brokers this represents an alternative avenue, but in both instances the key point would be finding a stock that would represent a sufficiently accurate proxy for the market to enable it to be used in this way.

In addition, many convertible bonds have high minimum dealing amounts.
I explained how to value convertibles in an article in this series about 18 months ago, but to recap briefly the key point is to establish the conversion premium.

This is the percentage discount between the effective conversion price at which a convertible holder effectively 'buys' the equity, and the current price of the shares.

An additional benchmark is the payback period. Convertibles typically have higher yields than the equity into which they convert. Dividing the extra income you get into the conversion premium gives you a measure of how quickly the additional income will extinguish the premium.
For example a convertible that yields 5%, versus an underlying equity yield of 2%, and that has a conversion premium of 18%, will have a payback period of six years. The 3% uplift in yield offsets the conversion premium over that period.
This is good for comparing the relative merits of different convertibles, but less use when trying to assess whether or not the convertible is intrinsically good value in its own right.

Peter says

I have not previously used either convertibles or options to hedge my equity portfolio or capture opportunities presented by elections.

On this occasion, however, I do feel that the market is taking far too relaxed a view of the outcome and that the election could provide scope for either disappointment or prolonged uncertainty.
This could be one of those occasions when strategies like this come into their own.
The issue remains how best to capture these opportunities. Companies like Autonomy, British Airways, Cable & Wireless, ITV, Pennon, Sainsbury and WPP all have convertible bonds that are regularly traded.

Many, however, have minimum dealing requirements of £50,000 nominal or more, which is a hefty price tag for many private investors.
Peter Temple is a regular contributor for Interactive Investor

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