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Analisi 11.04.2018

Investing late in the economic cycle

Investing late in the economic cycle

A market context favourable to convertible bonds

Key points

  • Historically, the convex nature of convertible bonds has provided investors with long-term benefits, such as equity-like returns, lower volatility and reduced drawdowns.
  • In addition, their embedded conversion option grants them much lower sensitivity to interest rate moves than straight bonds of similar duration.
  • In comparison with listed call options, convertible bonds’ embedded conversion option offers highly attractive benefits, including access to longer maturities and to a set of protection clauses.
  • The benefits of convexity make convertible bonds an “all-weather” asset class. However, certain market environments are additionally beneficial for the asset class. We believe that we are currently in one of them.
  • The normalisation process of monetary policies, which has started in the US and which should gradually spread across developed countries, poses increased interest rate risks for fixed-income instruments.
  • Although we remain positive on equities for 2018, the current late economic cycle offers potential for higher volatility and greater dispersion risk in equity markets.
  • Under such conditions, convertible bonds’ convexity and lower interest rate sensitivity are deemed to be beneficial. On top of this, their embedded long-term option constitutes, in our view, a key tool to face the current late-cycle challenges.

The long-term benefits of convertible bonds

Introducing convertible bonds

Convertible bonds are debt instruments. However, unlike straight bonds, they can be either redeemed at par on maturity, or exchanged for a defined number of shares of the issuing company during the life of the instrument. That choice belongs to the bondholder.

The combination of bond-like and equity-like features is at the root of convertible bonds’ asymmetric risk/return profile, also known as “convexity”. Their bond component grants them the defensive qualities of straight bonds (such as a bond floor and a regular income), while their embedded “call” option allows exposure to changes in the underlying stock’s price.

All other things being equal, the more the underlying equity rises, the more the convertible bond should participate in the upside, while the more the underlying equity falls, the less the convertible bond should suffer from its downside (Chart 1).

Convexity matters Historically, the convex nature of convertible bonds has provided investors with long-term benefits compared with equities. Some of these are equity-like returns, significantly lower volatility (Chart 2) and reduced drawdowns (Chart 3).

In the past twenty years, convertible bonds have suffered – on average – only 39% of equity markets’ downside in the European space and 49% in the global space (based on monthly figures). This should be put in perspective with their participation in positive equity months: 50% in Europe, 59% at global level.

Caution on interest rates

Relative to straight bonds, convertible bonds also offer key added value. To name but one: much lower sensitivity to interest rate moves, at similar duration.

This attractive feature comes from their embedded conversion option, which gains value with a rise in interest rates (all other things being equal) and hence partly offsets the negative impact on the bond component of the convertible instrument.

The hidden value in convertible bonds

Following the 2008 global financial crisis, so-called “prospectus clauses” have become increasingly common in the convertible space. The best known of them – the dividend protection and ratchet clauses –, have today become the norm in the asset class (Charts 4 & 5).

The mechanism of these clauses usually consists of an upward revision of the conversion ratio. They are designed to compensate the convertible bondholder for the potential detractive impact on the instrument value either of a dividend payment (dividend protection), or of a (potentially unwanted) takeover of the issuing company (ratchet). The formula applied is defined at issuance in the prospectus of the convertible issue. More rarely, they can take the form of cash compensation.

Often overlooked, prospectus clauses can still bring material, additional, long-term value to investors.

In any case, they are effective protection mechanisms against various events which can be part of an issuer’s life cycle, and strengthen the case for “plain vanilla” convertible bonds. While synthetic or structured products can try to reproduce the convex profile of a convertible bond, they do not offer investors similar protection.

The benefits of convexity make convertible bonds an “all-weather” asset class, where market timing is somehow less important. However, certain market environments are even more beneficial to the asset class. We believe that we are currently in one of them.

Investing late in the economic cycle

In 2017, the performance of equity markets was boosted by the combination of three main factors: accelerating global growth, surging corporate profits and central banks’ supportive monetary policies, in a context of moderate inflation.

With 2018 already well under way, we believe the first two pillars are still intact. Synchronised global growth is in place, economic growth is proving increasingly self-sustaining and corporate earnings remain on a strong path. In contrast, inflation dynamics could be a headwind to this overall supportive macroeconomic backdrop – more specifically, inflation picking up faster than expected.

Increased interest rate risk

The sharp correction we saw in early February is, in our view, clear evidence of how unpredictable inflation dynamics can be, challenging the forecasts of a gradual and smooth normalisation process of monetary policies and, in turn, those of a gradual rise in government yields.

In this context, convertible bonds’ intrinsic lower sensitivity to interest rates is deemed to be beneficial.

Looking at periods when 10-year yields increased significantly (more than 120 bp) in the past twenty years, both in Europe and in the US, clear patterns emerge (Chart 6).

During each of these periods (three in Europe, eight in the US – including the current period), convertible bonds systematically ended up in positive territory – sometimes even outperforming equities – when straight bonds reported systematically negative returns.

This may sound counter-intuitive. Being fixed-income instruments above all, one might expect convertible bonds to suffer from a rise in interest rates – albeit to a lesser extent than straight bonds, thanks to the partial “hedging” of their embedded option.

The fact is central banks do not hike interest rates out of the blue. Interest rate rises traditionally occur in healthy economic contexts – as is currently the case.

Eventually, the outperformance of convertible bonds over straight bonds, and their capacity to deliver positive returns during each of these periods, was primarily driven by the combination of two effects. On the one hand, the supportive behaviour of their underlying equity; and on the other, the partial “hedging” offered by convertible bonds’ embedded option against rising interest rates.

Convexity to face greater dispersion and volatility risk

With the economic cycle becoming more “late-cycle”, new challenges arise. These notably include normalising monetary policies by central banks – which should lead to higher interest rates –, higher equity valuations, especially in the US, and policy uncertainties. Combined with lingering geopolitical concerns, they offer the potential for higher volatility and greater dispersion risk on equity markets.

Greater dispersion may also be supported and exacerbated by market participants. With potentially less “beta” expected in 2018 on equity markets, various actors should favour stock-picking strategies that focus on alpha – either at sector or stock levels –, thus increasing the dispersion effect.

Under such conditions, convexity appears as a key asset to embed in one’s portfolio.

Thanks to their convex nature, convertible bonds allow investors to remain exposed to the additional upside potential of equity markets while keeping the defensive benefits of the bond floor.

Besides, were it to be confirmed after an initial spike in the volatility indices, a longer-term rise in volatility would trigger a positive revaluation of options. As such, investors can expect convertible bonds’ embedded conversion option to benefit from such a rise, adding value on the optional front.

Consequently, for investors who expect a higher volatility regime, we believe building “long-term option” positions can be an appropriate choice.

However, not all options are equal

Read the full document with charts


Nicolas DELRUE
Head of Investment Specialists & Convertible Bond Investment Specialist


Convertible Bond Investment Specialist


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