ptg7913109 ptg7913109 Beating the Indexes ptg7913109 This page intentionally left blank ptg7913109 Beating the Indexes Investing in Convertible Bonds to Improve Performance and Reduce Risk Bill Feingold ptg7913109 Vice President, Publisher: Tim Moore Associate Publisher and Director of Marketing: Amy Neidlinger Executive Editor: Jeanne Glasser Editorial Assistant: Pamela Boland Operations Manager: Jodi Kemper Assistant Marketing Manager: Megan Graue Cover Designer: Alan Clements Managing Editor: Kristy Hart Senior Project Editor: Lori Lyons Copy Editor: Karen Annett Proofreader: Debbie Williams Indexer: Lisa Stumpf Senior Compositor: Gloria Schurick Manufacturing Buyer: Dan Uhrig © 2012 by Bill Feingold Pearson Education, Inc. Publishing as FT Press Upper Saddle River, New Jersey 07458 This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional services or advice by pub- lishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent pro- fessional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or application of any of the contents of this book. Opinions expressed are those of the author and do not necessarily reflect those of BTIG LLC, its parent, affiliates, partners, members, officers, or employees. FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales. For more information, please contact U.S. Corporate and Government Sales, 1-800-382-3419, corpsales@pearsontechgroup.com. For sales outside the U.S., please contact International Sales at international@pearsoned.com. Company and product names mentioned herein are the trademarks or registered trademarks of their respective owners. All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher. Printed in the United States of America First Printing May 2012 ISBN-10: 0-13-288594-8 ISBN-13: 978-0-13-288594-2 Pearson Education LTD. Pearson Education Australia PTY, Limited. Pearson Education Singapore, Pte. Ltd. Pearson Education Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educación de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Library of Congress Cataloging-in-Publication Data Feingold, Bill. Beating the indexes : investing in convertible bonds to improve performance and reduce risk / Bill Feingold. p. cm. Includes bibliographical references and index. ISBN 978-0-13-288594-2 (hardback : alk. paper) ISBN 0-13-288594-8 1. Convertible bonds. I. Title. HG4651.F35 2013 332.63’23 dc23 2012004707 ptg7913109 For the three men I admire most: Sky Lucas, Chris Sferruzzo, and Franklin Parlamis ptg7913109 “Just because everybody’s doing it doesn’t make it right, and just because nobody’s doing it doesn’t make it wrong.” —Nicholas Arrigan ptg7913109 Contents Acknowledgments ix About the Author xiii Foreword xv Preface xix Introduction 1 Part I: Our Flawed Institutions Chapter 1 Indexing and Its Discontents 7 Chapter 2 The Individual’s Edge 25 Chapter 3 Delusions and Illusions: Chasing Performance in Our Lost Decade 43 Chapter 4 A Change Is Gonna Come 51 Part II: Convertibles, a Better Solution Chapter 5 The Very Basics 61 Chapter 6 Reminiscences of a Convertible Operator 69 Chapter 7 A Quick Review and Quiz 121 Chapter 8 Enough Already How Do Convertibles Actually Work? 145 Chapter 9 What to Look for in a Convertible 177 Chapter 10 Convertibles For 201 I. Individual Investors 201 II. Financial Advisors 213 III. Nontraditional Institutional Investors 217 IV. Corporate Financial Advisors 231 V. S t u d e n t s 249 Chapter 11 Introduction to Advanced Topics 257 Suggestions for Further Reading 285 Glossary 287 Index 291 ptg7913109 This page intentionally left blank ptg7913109 Acknowledgments I wouldn’t have been able to write this book without the support of my family—especially my wife Jennifer, who understands how I’m constantly wavering between the worlds of trader and writer and puts up with it. My daughters Abigail and Elizabeth give me daily joy beyond what I ever could have imagined. Any skill I have as a writer comes mostly from what my father, a retired English professor, taught me when I was growing up. His encouragement and praise are price- less because he never hesitates to tell me when he thinks I could and should have done better. I wrote this book while sharing a Westchester office with my close friend George Chuang, whom I first met at Lehman Brothers back in the late nineties. George is one of the best friends and best business- men I ever hope to know. He’s always graciously made a comfortable desk, complete with a great Internet connection and all the trim- mings, available to me during my sojourns away from Wall Street and into writing. Thanks also go out to his team at USB Media Company, especially Maggie Dobbins and Cristina Herrera. Also in Westchester, my good friend Dan Riseman, the hardest working man in education, has encouraged me by example and with humor. Dan’s not only a uniquely capable teacher and businessman, he’s also a fine writer, as his first novel, Dancing in Puddles, proves. Don’t miss it. To my horse-racing friends who have given me airtime on their investing programs, Gary Greco, Ron Olinsky, and Derek Simon, I say it’s always a pleasure to work with you. When it comes to friends I’ve met through racing who also know a thing or two about the markets, no one rivals Cary Fotias, the best handicapper I know, and a friend of 25 years who’s always supported my writing efforts. I also thank Mike Tolaney, another terrific handicapper and market student, for his good words and encouragement. I send out a special thanks to Tatyana Hube, who worked as a convertible research analyst at Merrill Lynch for more than 12 years, and graciously assisted with historical data. Other convertible pros who have aided and encouraged me at various stages throughout my career include Bart Baum, Brian Bentley, Sabina Bhatia, Frank Bianco, Tom Birkett, Mike Brailov, Doug Burke, Kevin Cadden, Joe [...]... I think the time for a change has come The wildness of the equity markets is scaring people away, people who know they need the benefits of stocks but understandably can’t stomach the downturns One of the best solutions is out there for them—convertibles A problem some people have with convertibles is that in the shortterm they often misbehave Even though they have built-in defenses making them far... you’ll find it The book has two distinct but related parts The first and shorter section, Part I, “Our Flawed Institutions,” addresses and expands upon the core of my first book, The Undoing of Cowardice I lay out the argument that the professional investment world is largely 1 2 Beating the indexes designed for mediocrity and job preservation at the expense of the creative, forward-looking asset allocation... only a few If you can invest with them, you should Chances are, they’re not accepting new investors If you can’t, then either invest on your own— the odds are far better than you think—or give a shot to a creative manager who isn’t afraid to underperform a benchmark If neither of these appeals to you, then just throw in the towel and stay middle of the road with a low-cost approach Whatever you do, don’t... on your own Indeed, one of the recurring themes of the convertible market is the periodic meltdown It seems to happen every four years or so and rarely has much, if anything, to do with the convertibles themselves or the companies that issue them It’s because of the narrow holder base—hedge funds and a small number of big traditional investors The hedge funds get most of their money from asset allocators... Beating the indexes Convertible bonds fuse together the worlds of stocks and bonds; and the securities my firm trades link the worlds of natural catastrophe insurance and bonds (catastrophe bonds) You may think stocks and bonds are not so obviously disconnected as earthquakes and bonds, but I will tell you that other than the common usage of the phrase “stocks and bonds,” stocks and bonds are the proverbial... opinion—because it’s not a one-size-fits-all world introduction 3 As such, this book is probably best for people—individual investors and professionals alike—who like to pick their own stocks but want help in finding the best way of structuring their investments I know there are a lot of you out there After we’ve learned how convertibles work—including the actual nuts and bolts of the trading process—and... proposal for another book, and xxii Beating the indexes I began to get excited After a bit of give-and-take, we agreed that I would write a book focused on bringing convertible bonds to a new audience, while also touching on some of the themes of institutional paralysis driven by an excessive focus on benchmarks and sameness that I began in Undoing They teach you in business school that having the greatest... Because during the conversation, my friend realized that his money manager had departed radically from the firm’s original approach “I get the sense they don’t think fundamentals matter any more, at least in the time frame they care about,” he told me “Now what interests them is if something is down 30% from its 52-week high It used to be they didn’t care about that stuff Now it seems like they are just... not because of any short-term performance concerns He’s thinking about leaving because the firm he originally invested with has changed, and not for the better He invested with them because he thought they had the resources and skill to discover investments he would never find on his own Now they are telling him they are just trying to buy the same stocks everyone else is buying—they’re just hoping to... friends in the convertible market over the years, but three stand out, and this book is for them I begin with Sky Lucas, my mentor, boss, and friend Sky is the best trader I’ve ever known because he refuses to define the game and the market in the penny-ante, shortsighted manner of the benchmark chasers Nobody has a better vision of where things are going, and nobody understands better the shortcomings . publisher. Printed in the United States of America First Printing May 2012 ISBN-10: 0-1 3-2 8859 4-8 ISBN-13: 97 8-0 -1 3-2 8859 4-2 Pearson Education LTD. Pearson Education Australia PTY, Limited and index. ISBN 97 8-0 -1 3-2 8859 4-2 (hardback : alk. paper) ISBN 0-1 3-2 8859 4-8 1. Convertible bonds. I. Title. HG4651.F35 2013 332.63’23 dc23 20120 04707 ptg7913109 For the three men I admire. Ltd. Library of Congress Cataloging-in-Publication Data Feingold, Bill. Beating the indexes : investing in convertible bonds to improve performance and reduce risk / Bill Feingold. p. cm. Includes