Financial markets ended 2019 the way they had started the year – on a bull run. Despite a few bumps in the road in between, investors who had approached 2019 with a risk-on mood and portfolio allocation were the big winners. As we start 2020, the question is this: what can we reasonably expect from here?
Following last year’s sharp rebound, global stock markets are back at historical highs. Risks, on the other hand, remain: global geopolitical tensions, developments post-Brexit and late-cycle challenges, to name but a few. In this context, with downside risk management becoming even more critical, a delta-one exposure to equity markets may be hard to hold for most investors. Yet, in the quest for returns within a bearable risk framework, alternative options are not plentiful.
With interest rates in the fixed-income space at historical lows and tight credit spreads, plain vanilla bonds’ yields are not enough to provide meaningful absolute returns on a standalone basis: equity sensitivity is needed.
Thanks to their dual nature – a bond component with an embedded conversion option –, convertible bonds allow investors to hold an equity exposure whilst keeping the defensive benefits of the bond floor.
The asymmetric risk-return behaviour of the asset class in the long run is well known. In addition to the long-term picture, recent quarters have shown that convertible bonds’ capacity to live up to their historical convexity produces benefits over shorter periods of time as well.
Looking back to 2018, which had its fair share of choppy stock markets, global convertibles demonstrated strong resilience compared with global equities, posting a performance of -4.4% when global equities were down 9.4% over the year. In turn, in 2019, with financial markets on a bull run, the asset class managed to capture 59% of global equities’ overall return (global convertibles +14.5%; global equities +24.6%). Such asymmetric behaviour – a -47% equity downside capture in 2018 (-4.4% vs. -9.4%) versus a +59% equity upside participation in 2019 – is precisely what convertible bonds are about. The outlook for 2020 is promising, with global convertible bonds ending the first month of the year ahead of global equity markets.
In addition to their convexity, convertible bonds also stand out from equities by the market structure itself.
In the current elongated market cycle, the global convertible bond market offers exposure to highly sought-after companies, whose businesses are linked to favourable secular trends that are less correlated to the overall softening economy. Among these trends, we particularly find value in the digitalisation of the economy, accelerating middle-class consumption in Asia and the ageing population.
For growth-focused companies, convertible bonds offer attractive financing terms through reduced interest payments in exchange for the conversion option.
In 2019, the technology, healthcare and consumer non-cyclical sectors accounted for close to 60% of the total volume of global convertible bond primary issuance.
For investors, convertible bonds represent an attractive way to access these sectors whilst containing their portfolio’s overall risk. The high volatility commonly shown by these growth stocks can be a drag for many investors. In comparison, convertible bonds allow them to hold their investment in these conviction names over time, including during small-to-mid-range market corrections.
As we head into 2020, with its share of uncertainties but also of hopes, we believe that the convexity profile of the asset class, combined with its privileged exposure to attractive secular themes, make it a strategic asset to include in portfolios.
Marc Basselier
Head of Convertible bonds
Scarlett Claverie-Bulté
Investment Specialist