The case for convertible bonds in 2021

investment viewpoints

The case for convertible bonds in 2021

Arnaud Gernath - Co-head of Convertible Bonds

Arnaud Gernath

Co-head of Convertible Bonds
Natalia Bucci - Co-head of Convertible Bonds

Natalia Bucci

Co-head of Convertible Bonds
Maxime Perrin - Head of Sustainable Investment

Maxime Perrin

Head of Sustainable Investment

Global convertible bonds demonstrated their merits in 2020 as the asset class outperformed both global equities and global credit1. As the pandemic progressed, convertibles proved their defensive characteristics from the bond element while still giving exposure to equity risk. As such, we see growing appetite following renewed interest from traditional equity and fixed income investors.

Such demand is illustrated by the healthy liquidity of the asset class as well as the relative attractiveness of convertibles compared to both equity and fixed income. In our opinion, convertibles also stand to gain in 2021 from volatility valuations, as we believe volatility is cheaply valued.

 

Convertibles vs straight corporate credit

Convertible bonds could offer an additional engine of performance compared to conventional corporate bonds, both in terms of investing in potential growth companies, and providing a buffer against possible inflation.

The negative yield environment has increasingly driven fixed income investors down the credit spectrum in search of higher returns, risking the illiquidity and poorer quality typically associated with such lower-rated debt.

Investing in convertibles enables investors to access a broader and more diverse issuer base. Contrary to standard corporate debt, buying convertibles also gives investors an embedded equity call option, offering the possibility of capturing the growth offered by equities.

High-growth companies are using the asset class to raise capital amid an active primary market.

High-growth companies are using the asset class to raise capital amid an active primary market. Indeed, total new convertible bond borrowing in 2020 was USD 158.6 billion (Figure 1), the strongest issuance since the 2008 financial crisis.

Figure 1. Convertible bond primary market issuance 1998-2020

Why-Converts-2021-CB-Issuance.jpg

Sources: UBS until 2017, Bank of America Merrill Lynch starting from 2018.

 

We also believe more and more  value companies will tap convertibles as their share prices begin to recover and they turn to the market to finance growth.

In addition, many of the companies issuing convertible debt could be well positioned to benefit from Covid-19-related themes and sustainability. The majority of 2020 new issuance fit into a theme we have dubbed “working and consuming from home.” And issuance from borrowers investing in renewable-energy firms was also notable.

In 2021, we also expect greater issuance driven by M&A activity and capital spending as the low-rate environment continues. Equity valuations are substantially higher now, making convertible bonds (and thus the issuance of equity call options) more palatable for issuers.

 

Inflation cushion

While the outlook is for global central banks to remain accommodative via both low interest rates and quantitative easing, the spectre of rising inflation has been a talking point. Convertibles could afford a measure of protection2 against potential inflation through their typically shorter duration, and the positive contribution of the optionality in inflationary environments.

In general, the asset class is less sensitive to interest rates than other types of bonds because of the embedded option, which usually gains value in times of rising interest rates. Secondly, the average duration of convertibles in our global strategy is 3.5years, enabling investors to lock in the shorter-term interest rate outlook without having to extend duration to ultra-long maturities where inflation risk is greater.

 

Convertibles vs equities

Convertibles could also look relatively attractive compared to straight equities. Current valuations in equities are historically high at a time when the outlook is clouded. Will equities continue to rally or might the market be in store for a correction? This could presage higher drawdowns in future.

With clear defensive properties, convertibles have in the past afforded higher risk-adjusted returns3 (Sharpe ratios) than conventional equities. The asset class gives continued exposure to highly valued equities through the optionality, while the bond element offers a measure of downside shelter should drawdowns rise. 

Currently, convertibles provide a healthy mix of opportunities in growth, cyclical and recovery names, thereby giving investors the possibility of varied exposure to equities, should the optionality conditions be met and exercised.

Lastly, convertibles are a source of liquid, long-dated options that are not available through any other financial instrument. This gives investors exposure to volatility, at a time when we believe volatility is attractively valued.

We believe that volatility is cheaply valued at the moment.

A bet on greater volatility?

Convertibles could provide an interesting play on rising volatility, especially because current valuations in the asset class appear cheap, in our opinion.

There are good reasons to anticipate further spikes in volatility in the months to come: coronavirus vaccination programmes might not progress as smoothly as hoped, inflation could rise more than anticipated, while the geo-political backdrop (especially the US relationship with China) could raise uncertainty or instability.

While we do not foresee the market experiencing volatility similar to March 2020 levels, valuations could rise marginally, or even undergo a correction from highs and then a rally.
We believe that volatility – as measured by the difference between realised and implied volatility (Figure 2) – is cheaply valued at the moment. Looking at historical volatility prices, we find that realised

volatility has been substantially higher than implied volatility since 2015.

 

Figure 2. Valuation of volatility

Why-Converts-2021-Volatility-Valuation.jpg

Source: LOIM. Spread (difference in percentage points) by region between implied volatility and realised volatility (260 days realised volatility). Past performance is not a guarantee of future results.

 

Such prices mean that investors would benefit from just a slight rise in volatility, and of course gain even more should volatility rise markedly.

The distinctive characteristics of convertibles could serve investors well in light of the potential scenarios unfolding in 2021, in our opinion. In particular, we believe balanced, global convertible bond strategies focusing on asymmetric profiles are well-suited to the investment landscape.
 

sources.

1 Past performance is not a guarantee of future results. For illustrative purposes only. Source: LOIM. Refers to the 2020 performance of global convertible bond index (Refinitiv Global Focus index ) vs global equities (MSCI World) and vs global credit (Barclays Global Corporate Credit, and the Barclays Global Corporate High Yield). Any reference to a specific company or fund does not constitute a recommendation to buy, sell, hold or directly invest in the company or funds. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the funds discussed in this document.

2 Capital protection is a portfolio construction goal that cannot be guaranteed.

3 Refers to Sharpe ratio comparison of LOIM convertible bond benchmark compared to equity benchmarks and high yield from 2004 to end-2020. Past performance is not an indicator of future returns. For illustrative purposes only.

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