investment viewpoints

    Convertible advantages in uncertain times

    Convertible advantages in uncertain times
    Natalia Bucci - Co-head of Convertible Bonds

    Natalia Bucci

    Co-head of Convertible Bonds
    Arnaud Gernath - Co-head of Convertible Bonds

    Arnaud Gernath

    Co-head of Convertible Bonds

     

    Need to know

    • The distinctive structure of convertible bonds could help investors navigate the current volatility and style rotation resulting from higher inflation and tighter US monetary policy.
    • We consider potential areas of advantage for the asset class such as timing, the supply backdrop and technical characteristics.
    • Our selection process aims to exploit current compelling valuations, regional idiosyncrasies, equity sensitivity and price dislocations.

     

    Volatility suits convertibles

    Volatility has become more pronounced as inflation concerns spur many of the main central banks, but most importantly the US Federal Reserve, to enter a tightening cycle. Geopolitical tensions from the crisis in the Ukraine have exacerbated sharp market moves.

    Such uncertainty creates conducive conditions for the asymmetric return profileof convertible bonds – one might say volatility actually suits convertibles. In light of today’s environment, what distinctive features of the asset class and supply trends could confer advantages?

     

    Shelter from equity volatility

    The prospect of higher funding costs is prompting a rotation in the stock market from growth to value companies, the third since early 2021. From an equity perspective, the exposure of the convertible bond asset class to names most sensitive to the rotation has decreased markedly since February 2021. Following repeated periods of rotation from growth to value names, convertible bonds issued by high-growth companies have now moved closer to their bond floors, providing some defensive properties relative to current stock prices.

    As many central banks commence policy tightening, investors are seeking a viable alternative to traditional fixed income strategies to hedge their portfolios against an equity market correction. Convertible bonds enjoy the dual advantage of providing an element of protection2 against market volatility and of lower direct exposure to interest rates, due to the embedded equity option.

    The share price sell-off means that some convertibles are now pure credit plays. They offer fixed income investors the possibility of owning an instrument with less exposure to interest rates and the option to participate in equity upside, should the share price rise sufficiently to restore some optionality. For certain issuers, convertibles are their only tradeable debt, offering additional potential to bond investors.

     

    How does supply favour a quality-focused approach?

    An extremely active primary market in 2020 and 2021 has created a deep pool of opportunities to invest in convertibles, beyond the unprofitable, high-growth companies which have fallen out of favour in the recent rotation. Our equity research team believes investors should not be overly concerned with choosing one style or the other. Rather, we focus on quality and seek to generate style-agnostic alpha in growth or value stocks.

    Convertible issuance enables investors to do just that. With around USD150bn issued in each of the past two years, the asset class benefits from new deals providing exposure to a diverse mix of investment themes and styles. For instance, blue chip companies such as Siemens, Ford and KPN3 came to the market. Notably, 2021 issuance contrasted with 2020 trends when supply from high-growth companies surged as they attempted to (re)finance during the Covid-19 crisis.

    Meanwhile, supply also enables investors to invest in companies leading the transition to net-zero carbon emissions. The substantial level of issuance in 2020 and 2021 not only grew the universe of global convertible bonds to approximately USD500m but also added a large number of solution providers providing inputs for companies directly involved in the climate transition. This ranges from semiconductors for electric vehicles and electric vehicle manufacturers themselves, such as Li Auto2, to electric power equipment manufacturers, including Schneider Electric2.

     

    Are technical factors favourable?

    Yes. The asset class is technically inexpensive in the current volatile market environment and displays a high level of asymmetry to equity market moves, according to our calculations. As shown in figure 1, many convertible bonds are now trading below what is deemed ‘fair value.’

     

    Figure 1. Convertible bond valuations: comparison of market price vs fair value

    Converts in uncertain times.svg

    Source: Nomura, LOIM. A price of 0 represents fair value. For illustrative purposes only.

     

    Navigating the months ahead

    We favour simple strategies in the asset class such as:

    • By region, maintaining selected exposure to China and favouring Europe over the US
    • Reducing names with no equity upside, uncompelling yield attributes and low-conviction credit profiles
    • Trimming holdings with high equity sensitivity to equity market rises
    • Buying names after they have cheapened due to further style rotations
     

    Our view. We believe the defensive characteristics of convertibles together with a quality-driven approach to selection could help investors weather the volatile environment and generate appealing risk-adjusted performance. 

    Sources

    [1] A brief recap on the asset class: convertible bonds are a hybrid instrument. The embedded equity option in a convertible bond gives it exposure to moves in stocks, while the bond characteristics could buffer investors from share moves by providing a bond floor. Convertible bonds therefore feature an asymmetric return profile that provides upside opportunity as well as downside protection.
    [2] Capital protection is a portfolio construction goal that cannot be guaranteed.
    [3] Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or securities. It should not be assumed that the recommendations made in the future will be profitable or will equal the performance of the securities discussed in this document.

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