investment viewpoints

Uncertainty suits convertibles

Uncertainty suits convertibles
Maxime Perrin - Client Portfolio Manager

Maxime Perrin

Client Portfolio Manager

In uncertain times, convertible bonds come into their own. The asymmetric return profile of convertibles offers investors the potential to participate in equity performance, while also providing protection1 from equity downside due to the bond element. Various factors bode well for this asymmetry in the current backdrop. 

We expect a volatile year for equities and risk assets in general, characterised by on-going uncertainty from geopolitical risk and reversals in monetary policy from the US Federal Reserve and other central banks. As such, our outlook for convertible bonds is quite positive for investors, as well as from an asset allocation point of view.

Convertible bonds could help equity investors weather future volatility in stock markets after the strong performance seen so far this year. In the early part of 2019, a rally in global stocks helped erase much of the selloff seen in the fourth quarter of 2018. Given this large move, and the fact the MSCI World Total Return Index has risen by more than 11% in the first quarter of 2019, equity investors could be motivated to de-risk their exposure here and cushion future returns from expected volatility. 

Convertibles enable investors to remain invested in an equity-correlated asset class, but the bond features buffer investors from the downside potential in equities. As such, investors could participate in further equity upside but with lower volatility for improved risk-adjusted returns.


The asset allocation case

From an asset allocation point of view, convertibles can benefit investors in several ways. Convertibles could give investors exposure to rising volatility, act as a diversifier in a portfolio and increase performance adjusted for volatility.

Convertibles are a simple way for investors to play the volatility trade, especially when times are uncertain. In an environment where volatility is expected to rise, convertible bond investors would benefit due to the equity option they own as part of the bond. But they would also be shielded from equity downside due to the bond element. 

Implied equity volatility, which reflects expected market movements in the future, is currently priced at very low levels2 to indicate past, subdued levels of volatility. Going forward, however, we expect the global backdrop to be characterised by uncertainty, and therefore support volatility. From a valuations perspective, equity optionality is available at an attractive price, we believe, further adding to the investment case. Investors should not forget that convertible bonds are one way to gain exposure to long-term, liquid optionality (typically 5 years at issue).

“Investors looking to diversify their asset allocation could find that convertibles offer sectoral and regional benefits.”

Investors looking to diversify their asset allocation could find that convertibles offer sectoral and regional benefits. On a regional basis, convertibles can give attractive exposure to emerging markets in Asia, or substitute existing exposure. This gives investors the potential to tap into the larger growth expected in the region. Depending on the strategy, the weighting can be as high as 20%-25%. 

Secondly, because the US is regionally less dominant in convertibles, it can diminish investor exposure to the US market. Currently, around 40% of the convertible bond benchmark stems from the US, compared to over 60% of the MSCI World index.

On a sectoral basis, investing in convertibles enables investors to diversify the exposure of their asset allocation. Generally speaking, convertibles tend to be less exposed to low growth sectors and more exposed to high growth sectors. Traditional bond issuance in credit markets predominates in low growth sectors, such as utilities, telecoms, financials and energy, where companies have become increasingly leveraged since the financial crisis a decade ago.

Convertible issuance, in contrast, tends to be have a heavier weighting to higher growth sectors - such as technology, healthcare, consumer cyclicals and industrials – than traditional equity and bond strategies. This is because debt issuers in these sectors tend to capitalise on the future expected growth of the company’s shares by selling the equity option to investors in the convertible, and enabling investors to participate in equity upside. With significant allocations to sectors such as technology or industrials, convertible strategies could be particularly attractive to complement a traditional dividend strategy focused on large-cap value stocks, for example.

Lastly, convertibles can offer investors attractive returns on a risk-adjusted basis, as measured by the Sharpe ratio. Over the long-term, convertible bonds have generated similar returns to equities but have done so with lower volatility, resulting in higher risk-adjusted returns over long-term periods3. We believe this asymmetric return profile makes convertible bonds attractive to investors in need of the growth potential of the equity market, but wanting to reduce their exposure to equity-market volatility.

There are, of course, risks also associated with convertible bonds. These include the typical risks associated with corporate debt (eg default risk or interest rate risk), as well as risks associated with equity call options (eg an equity correction leading to the devaluation of the option).

Overall, in today’s environment of increased volatility and ambiguity, the outlook for convertible bonds is quite positive and can help investors weather uncertain times.


Please find key terms in the glossary



1 Capital protection represents a portfolio construction goal and cannot be guaranteed.
2 As measured by the VIX index from 2010 to 2019. Source: LOIM calculations, Bloomberg. Past performance is not a guarantee of future results.
3 Analysis period 31 December 2004 to 31 July 2018. Sources: Equities: MSCI World TR (EUR-hedged); LOIM Convertible Bonds Strategy (gross); TR Global Focus Index: Thomson Reuters index (EUR-hedged); TR Global Focus IG Index: Thomson Reuters index (EUR-hedged). Past performance is not a guarantee of future results.

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