investment viewpoints
Finding converts in fixed income
As higher yields have come back into play in corporate credit markets, we believe convertible bonds stand out within the various fixed income asset classes. Many convertible bonds from borrowers with strong balance sheets can now be priced as "straight" fixed income owing to their free option, high bond floors and generous yields. Still, not all corporate credit spreads are created equal: many convertible bonds are currently yielding more1 than straight bond equivalents with the same seniority and from the same issuer.
In addition to this price discount opportunity, investors should add the potential added benefit of the embedded long-term equity call option within a convertible.
As such, convertibles potentially offer a rare value proposition for investors at the moment, in our opinion: a generous yield on quality senior debt, and a heavily discounted long-term option on the equity rebound.
Why are convertibles yielding more?
In a nutshell: technical dislocation. Covid-19-driven technical dislocation means many converts are currently priced at a discount to plain vanilla credit from the same borrower, despite having equivalent seniority and credit risk. The dislocation stems from the indiscriminate selloff in the corporate bond market since March. Illiquid trading conditions often amplified this disconnect between bond pricing and company fundamentals.
Central bank intervention further exacerbated the dislocation because quantitative easing programmes do not include convertibles. As central banks thus focus on buying straight corporate debt, convertible credit spreads are left wider, even though the instrument has the same issuer risk and seniority as the straight debt.
How much more are convertibles yielding?
Additional credit spreads could be significant for good quality, well-known convertibles, in our opinion. For example, depending on timing, some convertible credit spreads could be twice the equivalent vanilla bond spread from the same issuer, mostly in investment grade space in the major hard currencies1.
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For instance, as of 21 April, the indicative credit spread on an A rated convertible bond due 2022 was 336bps, compared to the same issuer’s bond due 2024 with a credit spread of just 189bps. Both deals are senior unsecured and denominated in EUR1. The yield differential resulting from this dislocation was 147bps (3.0% yield for the convertible bond vs. 1.5% yield for the straight debt from the same issuer)
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Similarly, as of 21 April 2020, the indicative credit spread on a BBB rated convertible bond due 2021 was 150bps, compared to the same issuer’s bond due 2022 with a credit spread of just 20bps. Both deals are senior unsecured and denominated in JPY1. The yield differential is 73bps (0.9% yield for the CB vs. 0.17% for the straight debt)
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Lastly, as of 20 April, the indicative credit spread on a BB+ rated convertible bond due 2024 was 547bps, compared to the same issuer’s bond due 2026 with a credit spread of just 346bps. Both deals are senior unsecured and denominated in USD1. The yield differential is 70bps (4.6% yield for the CB vs. 3.9% for the straight debt)
What about the equity call option?
Let’s not forget that convertible bonds also contain an equity call option, enabling the investor to convert into the underlying shares under certain conditions. Currently, this option is heavily discounted or valued at zero for a large pocket of the convertible bond universe. This means the option comes at virtually no additional cost to the investor even if it still has potential value.
The value of the options is to provide a rare source of longer-dated optionality not available elsewhere as a liquid instrument. If the market recovered, these options could quickly re-price, and the valuation of convertible bonds would jump significantly as a result. Indeed, this is why convertible credit spreads are usually tighter than straight debt to reflect the optionality – but many convertible bond spreads are currently larger!
In the meantime, investors already receive the additional spread pick up vs convertibles’ siblings, regardless of whether or not the optionality kicks in. And convertible investors stand just as good a chance of getting their money back as other fixed income investors2.
What are the risks?
The general credit risk incurred by an investor when buying a convertible is equivalent to that incurred from a straight debt equivalent – after all the issuing entity is the same as is the seniority of the debt in the overwhelming majority of cases. As for all fixed income investments, avoiding lower calibre credit (and thus potential defaults) is crucial2. In this respect, we note convertible issuers are mostly from low financial leverage sectors, for instance technology and healthcare. Sectors more impacted by Covid-19, such as energy, transport and travel, are typically much less represented in the convertible bond universe.
How long will this last?
Today’s generalised price dislocation repeats, to some extent, past crises such as the global financial crisis in 2008. Previously, dislocations have gradually corrected and in general, better quality credit will correct more quickly. This means windows of opportunity can close just as fast as they opened, and investors would do well to capture current dislocations while they last. We believe that time is now.
Convertibles could be one of the better and easier-to-implement anti-cyclical plays manifesting in today’s disjointed markets. Fixed income investors who can be flexible in their thinking and implementation could find convertibles offer superior returns for the same risk as a standard bond.
