Convertible bonds: a low governance equity hedge

investment viewpoints

Convertible bonds: a low governance equity hedge

June 27, 2019

Maxime Perrin

Head of Sustainable Investment

Ritesh Bamania

Head of UK and Ireland Institutional Clients and Solutions

Marek Siwicki

Head of Consultant Relations

Uncertain times call for resilient portfolios, particularly for pension schemes and insurers holding equities.

Equity holdings are exposed to the current uncertain environment as global markets are buffeted by geopolitical risk, including the US-China trade war. This has led to volatility in stock indices globally, amid some correction from the very highs hit in early 2019.

Convertible bonds could provide a flexible solution to address some of the equity drawdown issues facing pension schemes and insurers.

Convertibles are corporate bonds with an embedded equity call option. This hybrid structure means that convertible bondholders tend to be less exposed to falls in share prices than a customary equity holder because the bond element enables them to effectively dampen the equity downturn.

Strategically, convertible bonds have provided attractive risk-adjusted return characteristics compared to traditional equity allocations¹.

Convertibles could also be a powerful alternative to equity options, in our view. Firstly, investing in convertibles requires a less onerous governance framework than that required for equity options. Secondly, convertibles have, on average in the past, provided better protection against volatility than some equity option strategies².

Investors could use convertibles to temper the exposure of their equity allocation to volatility by rebalancing part of the equity allocation away from equities and towards convertibles. Reducing the equity allocation by 30% and replacing this with convertibles has historically protected a portfolio during drawdowns by approximately 20%³.

It is important to tailor the convertible bond mandate to suit specific investor needs, and to optimise the distinctive features of the asset class.

We believe that convertible bonds offer compelling arguments to mitigate exposure to volatility, both in terms of the asset class’s higher Sharpe ratios and its lower governance features compared to equity options.

Please find key terms in the glossary

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sources.

¹ Based on historical analysis of a convertible bond portfolio vs MSCI World TR (EUR-hedged) from Dec 2004 to December 2018. Sources: LOIM, MSCI. All figures EUR-hedged. For illustrative purposes only. Past performance is not a guarantee of future results.

² Based on a convertible bond strategy vs 1 year (rolling) equity option strategy from 2010-2018. Equity option assumes a zero-cost put spread collar. Sources: LOIM, Bloomberg. For illustrative purposes only. Past performance is not a guarantee of future returns. Capital protection represents a portfolio construction goal and cannot be guaranteed.

³ Past performance is not a guarantee of future results. For illustrative purposes only. Source: LOIM. Refers to periods such as March-April 2005, October 2008-March 2009, April-July 2010 and August-September 2015.

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