After a strong start into the year, doubts have returned to the financial markets, primarily driven by central banks’ rhetoric and developments in the US–China trade conflict. Against this challenging backdrop and with an ultra-low-yield fixed-income environment, the traditional “equity/bond” allocation is constantly being put to the test. On the one hand, there is still upside potential for equities: so far, global growth has been resilient and central banks have maintained their accommodative stances; nevertheless, short-term corrections are to be expected given the lingering uncertainties.
On the other hand, yields have decreased substantially year-to-date and are not sufficient to deliver attractive long-term returns.
In this context, convertible bond strategies constitute a solid alternative for investors thanks to their convexity: their ability to limit downside risk due to their bond floor while benefitting from a substantial part of stock market rallies. Whereas some see this as complicated, we see it as an asset.
Because of their dual nature – a bond component with an option to convert it into an underlying share – convertible bonds combine features of both bonds and equities. This is at the root of their specific risk-return profile. Convertible bonds’ specific profile is best described as non-linear relative to equities. In other words, convertible bonds offer an asymmetric return in comparison with a standard equity profile. This is known as “convexity”.
Convexity is found in the convertibles’ ability to limit downside risk due to their bond floor, while at the same time benefiting from a substantial part of stock market rallies.
It is precisely this convexity which attracts investors to the asset class: for an equivalent upward or downward movement in their underlying stock, convertible bonds tend to capture more of the upside than the downside (see Chart 1).
Historically, the convex nature of convertible bonds has provided investors with long-term benefits in comparison with risky assets. Over a complete market cycle, convertible bonds, relative to equities, have demonstrated their capacity to deliver similar returns, with half the volatility and reduced drawdowns (see Chart 2).
Convexity can also prove beneficial over the shorter term, as was the case last year: although global equity markets suffered a sharp correction, global convertible bonds proved resilient.
In 2018, our flagship global convertible bond strategy was down by only -3.8% while global equity markets were down -9.4% – as shown by the MSCI World TR Hedged EUR, the biggest drop for this index since the great financial crisis of 2008. This performance corresponds to a 40% equity downside capture with the additional benefit of a lower volatility (8% versus 13%).
Year-to-date, the same strategy of convertible bonds is up 8.22% compared with 14.19% for global equities. This means that in 2019’s risk-on mode, 58% of the equity upside has been captured.
This is an excellent example of an asymmetric return profile defined as convex (see Chart 3).
Enhancing convexity is at the core of UBP’s investment approach. One way to achieve this is to select stocks exposed to secular trends themes with solid earnings growth potential in the mid-to-long term and less correlated to the overall softening global growth environment. These trends include the ongoing digitalisation of the economy, increasing healthcare needs of an ageing population and growing consumerism in Asia’s middle-class. They are all well represented in the convertible bond space.
We design our convertible bond strategies through a unique process based on five pillars:
- Bottom-up security selection focused on convexity
- In-depth fundamental analysis of the underlying equity as a performance driver
- Close attention to credit quality
- Long-term management aiming to generate value in different market cycles
- Discretionary management of the portfolios’ exposures (equities, interest rates)
Our range of strategies has been designed to use the richness and diversity of convertible bonds through:
- Defensive convertible strategies (with a defensive equity-sensitivity profile)
- Core convertible strategies (with a dynamic equity-sensitivity profile)