An obscure investment opportunity in Asia

During a panic, some of the best investment opportunities come out of smaller markets where liquidity dries up. Take Asian convertible bonds, which have been severely mispriced in the last few weeks.

Convertibles are bonds that have the option to convert into a fixed number of shares in the company. As long as the share price is high enough to make conversion worthwhile, this conversion option has value. So a convertible shouldn’t trade at a lower price than a comparable non-convertible, and will usually trade at slightly more.

But the Asian convertible market is much smaller and less liquid than the conventional bond market. There are around 250 convertibles outstanding against around 3,400 conventional bonds, according to Bloomberg data. So when pricing falls apart, convertibles can end up offering much higher yields than conventional bonds.

This happened during the global crisis. And it’s happened again in the last few weeks. To take an extreme example, the yield to maturity on convertibles from Indonesian miner Bumi Resources has recently been five percentage points more than its conventional debt. At times like that, convertibles look especially attractive.

In the short term, if markets snap back, convertibles will usually rise much more than conventional bonds because of their equity option. If they don’t, at least you hold a bond with a respectable yield.

In the longer run, good quality convertibles look like an interesting option for building a portfolio that hedges against the uncertainty over the inflation / deflation debate (I look at in more detail in this week’s MoneyWeek Asia). Amid deflation and falling share prices, convertibles offer income and fixed value at maturity. Otherwise, they can be transformed into shares that have a chance of beating inflation in the long run.

Unfortunately, for most of us, direct investment in bonds isn’t viable due to costs and minimum deal sizes. And with Asian convertibles still a niche, though a growing one, there aren’t many funds so far. I know of three from major providers, although they will probably be a bit of work to get hold of.

The Parvest Asian Convertible Bond Fund from BNP Paribas has a 15-year history and reasonably good performance. The Schroder ISF Asian Convertible Bond Fund has been running for two years, while Lombard Odier’s LO Funds Convertible Bond Asia is the newest entry, having started in December 2008.

Asian convertibles are certainly a niche area. But adventurous investors might at least want to have it on their hotlist for the next panic.