An environment in which rates are rising traditionally favours convertible bonds. What is more, at times of market volatility, convertibles’ convexity remains a rare and precious asset.
2016 was a year of contrasts on the convertible bond market in Europe. On the one hand, the European primary market maintained a positive dynamic (USD 29.1 billion in new issues compared with USD 25.6 billion in 2015). The European market has been in a state of continuous expansion since 2012, and, in 2016 alone, it contributed close to USD 11 billion to deposit growth.
On the other hand, the increase in risk aversion has brought about capital outflows from open UCITS funds that are domiciled in Europe and which specialise in convertibles. It is also the longest and most substantial series of outflows seen in the last decade. That said, this needs to be viewed in context: some of these outflows have been shifted into dedicated solutions to ensure the right match between managers’ goals and those of their clients, by integrating the specific regulatory and supervisory environment. Further, relative to similar periods in recent history (such as 2008 or 2011, when performances were highly negative with falls of 27% and 10%, respectively), performances have remained close to balance in 2016, showing the capacity of all convertible managers to adapt to a less favourable environment.
In 2017, the theme of reflation will dominate the agenda for the markets. The macroeconomic environment, coupled with the return of inflation and a re-steepening of rate curves, are once again piquing interest in convertible bonds among both issuers and investors.
Convertible bond issuers will be able to make more significant savings on their debt costs, whereas in a zero-interest-rate environment, the marginal savings were weak. This could be reinforced by US tax reforms, which, along with a drop in the corporate tax rate, pave the way for interest charges to no longer be deductible.
For investors, an analysis of performances over more than fifteen years shows that during periods of rate rises, convertible bonds put in positive performances, sometimes even outperforming equity markets (in contrast, corporate bonds saw declines).
“In this environment of rising rates and steepening of curves, we expect an increase in new issues. The financing of new infrastructure projects in the United States should support this trend. New issues should total more than USD 80 billion,” believes Jean-Edouard Reymond, head of the convertibles team at UBP Asset Management (France).
The market profile is adapted to the growth environment. European convertibles are marked by the strong presence of industrials, energy and materials. In the global convertibles universe, technology is the dominant sector and equity sensitivity has gone up to over 45%.
Political uncertainties in Europe (such as the upcoming elections in France and Germany, and the Brexit negotiations) and questions being raised in the United States about the new administration’s plans, along with the speed with which they are rolled out, are also liable to increase the risk of volatility on global equity markets.
All of these factors are clearly beneficial for convertible bonds in comparison with equities and classic bonds.
“Today in Europe, we are favouring consumer assets in an effort to make the most of a more favourable growth environment, as well as industrial names within our dynamic European strategy, so as to play the US infrastructure recovery theme, along with the upturn in construction in Europe. Lastly there is energy for the expected improvement in cash flows, with a preference for integrated oil companies,” says Jean-Edouard Reymond, who, however, remains cautious on utilities (namely public services) and telecoms, where one has to be highly selective. In the United States, within our dynamic global strategy our sectoral overweight is mainly targeting those technology and communications assets that create the most value. The Asian market has to be approached with caution given the level of dollar debt, which is set to weigh on the profitability of several names and, more generally, the increased risk of protectionism coming out of the United States.
Head of Convertibles