What are the current developments in favour of convertible bonds?
Historically, the convex nature of convertible bonds has provided investors with long-term benefits. These notably include equity-like returns with significantly lower volatility and reduced drawdowns. As a result, convertible bonds are traditionally considered as an “all-weather” instrument in regard to portfolio construction. That being said, certain market environments can be particularly beneficial to the asset class. We believe we are currently in one of them.
Although the macro picture remains business-friendly overall and should continue to provide fundamental support for the market, concerns keep weighing on investors’ sentiment, and are offering the potential for greater volatility: the aging of the cycle; inflation dynamics and the path of interest rate hikes by central banks, especially in the US; and rising protectionism.
In such a context, convertible bonds’ convexity makes them a strategic asset to navigate markets’ ups and downs. Thanks to their dual nature, they allow investors to maintain a certain exposure to equities’ additional upside potential, whilst keeping the defensive benefits of the bond-floor. Besides, a longer-term rise in volatility should trigger a positive repricing of options, thereby supporting convertibles’ valuations through their embedded conversion option.
Furthermore, the ongoing normalisation of monetary policies can be accompanied by sharp changes in market conditions. The recent surge in the US 10-year bond yield, from 2.4% at the end of 2017 to above 3% today, is a clear example. In this context, convertibles’ intrinsically lower sensitivity to interest rates relative to comparable straight bonds is generally considered beneficial. This attractive feature comes from their embedded conversion option: their revaluing with the increase in interest rates partly offsets the negative impact of such a rise on their bond component.
What are the biggest risks specific to convertible bonds?
Because of their dual profile – partly credit, partly equity-sensitive – the value of convertible bonds will react not only to factors that affect fixed income but also those that affect equity instruments. To name a few: evolutions in the underlying stock price, dynamics on interest rates and credit spreads, and volatility.
That being said, history has shown that, in the long-run, the convex nature of convertible bonds has enabled them to make the most of favourable stock market environments, whilst suffering less in challenging conditions. Figures speak for themselves: in the past 20 years, the Thomson Reuters Convertibles Europe Focus index (EUR) has posted an annualised return of 2.8% with annualised volatility of 7%*; over the same period, the Stoxx Europe 50 NR has delivered an annualised return of 0.7% with nearly three times the volatility (21% annualised)*. At a time where investors can expect greater dispersion in equity markets, such convexity constitutes a rare and valuable asset.
Rising interest rates is another challenge for investors today. As they are fixed income instruments, one could expect convertible bonds to suffer from a rise in interest rates. However, history has shown that periods of rising interest rates were often paired with positive equity momentum and thus eventually benefited convertibles. During each period in the past 20 years where the 10-year Bund yield (in Europe) or the 10-year US Treasury yield soared by more than 120bps, the gain on the convertible’s option more than compensated for the loss on the curve, resulting in positive returns overall for the asset class.
Have convertible bonds suffered from the expansionary monetary policy of recent years?
Since its inception, the ECB’s quantitative easing has induced a sharp distortion across the traditional bond market – from sovereign to corporate bonds, and from investment grade to high yield – draining the opportunities in terms of spreads and maintaining downward pressure on yields.
At current historically tight spread levels, and as we are gradually moving from a market driven by flows and liquidity to a market driven by fundamentals, corporate bonds thus appear more vulnerable to greater dispersion risk. Comparatively, not being part of the eligible assets for the ECB’s purchases, convertibles have remained relatively preserved from this distortion effect. This – combined with their relatively lower interest rate sensitivity – constitutes a strong call in favour of the asset class for investors looking to diversify their investments in the fixed income space.
In recent years, especially in 2017, equity markets have performed very well, while bonds have been unprofitable. How has this affected convertibles?
The overall performance of convertible bonds can be split into three main factors that can evolve in different ways depending on the market context: first, the bond component, whose core drivers are credit, carry, yield and curve effects; second, the equity component, which will be supported by the underlying stock price; and third, the pricing of the option component itself. Such diversity of performance drivers gives the asset class a competitive edge, insofar as it grants them the potential to generate value in different market conditions.
In 2017, in a highly propitious environment, the asset class was driven primarily by the underlying equity component. So far this year factors have been more diverse. The “Gamma” effect in particular (the automatic adjustment in convertible bonds’ equity sensitivity with underlying equity moves) contributed actively to the resilience demonstrated by convertibles during equity markets’ sharp correction in Q1. Looking ahead, with higher volatility expected in the markets, the option component of convertible bonds could return as a core driver of performance for the asset class.
From an issuance perspective, the current environment constitutes very fertile ground for convertible bonds. With equities at (still) elevated levels and the upward trend on interest rates, corporates are increasingly considering convertibles in their funding strategy. This is well evidenced by the currently strong issuance figures, especially in the US where a significant proportion of the recent new issues came from new players in the convertible space – a favourable dynamic which contributes to increasing diversification in the universe. From companies’ standpoint, the lower coupons offered in the convertible space – in exchange for the embedded conversion option – constitute a powerful argument for the asset class.
What do investors need to know before investing in a convertible bond fund?
Convexity is the main reason why investors make the choice of adding convertible bonds to their asset allocation. Yet, convexity should not be taken for granted. The higher its equity sensitivity profile, the more the convertible bond will move away from the bond-floor and hence, the closer its price will be to that of the underlying stock. This should prove beneficial in a supportive context for the underlying stock, but embeds greater downside risk in the event of a downturn. Conversely, the lower the equity sensitivity, the more the convertible bond will behave like a pure bond, with its defensive benefits, but somehow losing the upside potential on the underlying stock. With that in mind, sound stock picking, focused on each convertible’s specific features, is key to building a portfolio with enhanced convex features.
In our search for convexity, we favour convertible bonds that offer a cheap option feature – and therefore greater convexity potential. The credit quality is another key pillar of our approach. Convertible bonds being first and foremost fixed income instruments, nothing can affect them more than a default. Our careful credit analysis aims to select convertible bonds with a solid bond-floor, which should provide effective defensive benefits in case of a drawdown on the underlying stock.
Nicolas Delrue
Head of Investment Specialists and Senior Investment Specialist Convertible Bonds