And indeed, convertible bonds were no exception, being affected by the fall in value of their underlying assets, coupled with the valuation of their options – a key performance driver in the asset class – along with the bond and equity components.
What happened in the European convertibles universe in 2016 can be put in perspective, relatively speaking, against the situations in 2008 and 2011, namely, an overselling of the asset class, which reflected investors’ choice to turn their backs on risk equities. In each of these periods, convertibles’ performances were dominated by outflows to the detriment of fundamentals. In 2016, capital outflows seen by convertible bond funds domiciled in Europe totalled some EUR 9.6 billion. In comparison, outflows reached EUR 7.2 billion in the wake of the subprime crisis and EUR 7.6 billion during the eurozone sovereign debt crisis (Source: Morningstar).
The impact of outflows on convertibles’ valuations is also reflected in the price of options (implicit volatility), which corrected sharply in the first half of 2016, particularly in Europe. Over this period, implicit volatility nosedived from 32.5% to 24.7%. Since this low, the trend has started to reverse, to the benefit of the asset class. At the end of January 2017, European convertibles’ implicit volatility was, however, almost two points below its four-year average. Since the beginning of the year, we have seen signs of investor interest in the asset class, which suggests that the outflow trend is reversing.
This low-implicit-volatility environment has opened up great opportunities in terms of bottom-up selection. This means that, under the effect of the drop in value, some convertibles have begun to show yield-to-maturity levels higher than those of equivalent classic bonds. In each of these cases, the convertible bondholder enjoys a yield-to-maturity that is greater than a call option on the underlying asset.
To give an example, the convertible bond issue by Veolia offered a yield-to-maturity of 0.41% at the end of December, 30 basis points (bp) above the issuer’s classic bond of comparable maturity. The same applied to convertibles from other issuers, such as Unibail and America Movil.
While convertibles put in below-expectation performances in 2016 compared with their track record, they kept their long-term promises in terms of providing downside protection and reducing volatility. The post-Brexit period is a prime example of this. From 23 to 27 June 2016, the Stoxx Europe 50 NR index only shed 9.1%, whereas the Thomson Reuters Europe Focus Convertible Bond (EUR) only gave up 3.7% (Source: Bloomberg Finance L.P.). The advantages of convertibles over equities in terms of risk-adjusted yield remain unchanged over the long term.
Over the coming months, convertibles’ unique characteristics should enable the asset class to stand out from equities and traditional bonds.
In mid-December, the US Federal Reserve announced that it would raise interest rates by 25 bp and warned investors to expect further rate rises in 2017. The impact of this announcement went beyond US borders; it was also felt via an “imported” rate rise on European rate curves, which also exposed investors on the other side of the Atlantic to a risk of loss on their fixed-income investments. The appearance of this risk, combined with yields in the traditional bond universe that remained unattractive, triggered a search for alternatives.
In parallel to this, equity markets should benefit from the return of inflation, in line with the promises made on the election trail by Donald Trump (such as tax breaks and a massive public spending programme) and the OPEC agreement on reducing oil production, which are factors that suggest a new phase of appetite for equity risk, which should see the outflow trend reversed.
However, the risk of increased volatility should not be downplayed given the number of sources of uncertainty that persist, such as upcoming elections (especially those in France and Germany) whose outcomes are highly uncertain, developments surrounding Brexit, the policies of the new US administration, and the future steps to be taken by central banks.
This sort of environment is good news for convertibles. In comparison with classic bonds, they offer investors less interest rate sensitivity with an equivalent duration thanks to their options, which increase with interest rate rises. Further, in a reflationary environment that favours equities, convertibles allow investors to benefit from any bullish potential through their underlying assets while still benefitting from the bond floor – a major advantage that, historically, has enabled the asset class to mitigate the volatility risk of equities.
In every period over the last fifteen years when 10-year German Bund or US 10-year Treasury returns have risen by more than 120 bp, the combination of these advantages – lower interest rate sensitivity, limited exposure to risk assets and the bond floor – has enabled convertibles to outperform classic bonds and, in certain cases, to deliver a performance better than that of equities.
Nicolas Delrue
Head of Investment Specialists