investment viewpoints

What’s the outlook for convertible bonds in 2024?

What’s the outlook for convertible bonds in 2024?
Arnaud Gernath - Chief Investment Officer, Convertible Bonds

Arnaud Gernath

Chief Investment Officer, Convertible Bonds
Lydia Chaumont - Head of Client Portfolio Managers for Convertibles

Lydia Chaumont

Head of Client Portfolio Managers for Convertibles

We expect 2024 to bring lower growth and disinflation, but without a hard landing. US rate cuts are unlikely until H2 while China has limited room for significant stimulus. In this base-case scenario, many supportive factors – from regional bias to supply dynamics and valuations – bode well for convertible bonds. 

By region, we prefer the US and Japan over Europe and Asia. We also consider which investment themes stand to benefit, including semiconductors, cybersecurity and cloud spending. An active primary market, inexpensive valuations and an expected uptick in volatility should also prove supportive, in our view. Lastly, we consider how convertible bonds could benefit investors in the context of a multi-asset approach.


Please explore the sections below to read our outlook.

  • We see three possible scenarios for markets in 2024. A recession, a more benign scenario, and a strong market rebound. The more benign scenario is our base case, and most likely, outcome. Several key medium-term convictions underpin our expectations:

    • Disinflation is underway, though the pace of future falls in inflation could slow relative to previous decreases
    • Despite a lower growth environment globally, we do not expect a hard landing
    • Developed-market interest rates (both short and long-term) will remain high for longer and the Federal Reserve is unlikely to cut rates until H2 2024
    • There is limited room for China to lower rates and to implement significant stimulus. There could be outflows of foreign capital if the CNY weakens further against the USD. We expect a continuation of targeted measures in key areas
       

    If our base case is correct, we believe that corporate margins will remain stable, which in turn will support 2024 earnings per share (EPS) growth, albeit at a slower pace than is currently forecast. We have more confidence in corporate/government spending than consumer spending as the savings rate decreases but fiscal stimulus remains possible. We prefer companies exposed to rising capital expenditure (infrastructure and technology budgets) such as cybersecurity and cloud computing, and remain underweight in automobiles, retail, payments and luxury, at least in the short-term.

    Geopolitical risk is likely to persist, meaning that oil and gas prices could remain volatile and skewed to the upside. Energy names could provide a hedge if regional conflicts escalate. Our Global convertible bond strategy remains underweight sectors which are negatively impacted by a higher oil price in the broader transportation industry, specifically in airlines and shipping. A higher oil price also creates headwinds for consumption.
     

  • As a result of the prevailing macro dynamics and geopolitical backdrop, we prefer the US and Japan (where we are neutral to positive) over Europe and Asia (where we are neutral to negative). 

    In the US, the combination of strong labour markets and limited wage pressures has helped consumer spending remain robust, despite the gradual normalisation of household savings rates towards pre-Covid levels. Recent data releases, including the latest GDP figures, are consistent with this situation continuing, thus reducing the medium-term risk of a hard landing.

    We view Japan as a beneficiary of growth in Asia without the political and macroeconomic turmoil. Japan could benefit from potentially exiting from deflation, rising real wages and improving corporate governance. We remain overweight Japanese companies exposed to post-Covid reopening, and exporters who benefit most from a weak JPY. We are monitoring the situation closely in the light of potential changes to the Bank of Japan’s yield curve control policy.

    Economic growth in Europe, especially in Germany, is likely to disappoint. Higher energy prices, depressed activity data and growing concern over Italy’s debt sustainability look set to weigh on sentiment. Weakness in China is a drag globally but especially for Europe, due to its heavy reliance on exports to the region.

    We remain neutral in the short-term on China due to the limited potential for the People’s Bank of China (PBoC) to reduce rates further and for central government to implement a significant stimulus program to boost consumer spending. We expect targeted support for key strategic sectors, especially for property-related names, to continue. 

    Nevertheless, getting the timing right for adding or reducing exposure to China will remain tricky. Short-term, we believe there may be upside risk for Chinese equities due to inexpensive valuations and light investor positioning. Greater-than-expected fiscal stimulus could trigger a market rally. Longer-term, considering the numerous structural headwinds – such as demographics, youth unemployment and geopolitics – we remain cautious on China.

    In 2024, Asian convertible bonds could help investors maintain exposure to growth in the region, solve timing issues, navigate macroeconomic uncertainty by providing convexity and offer higher yields than those available from issuers of similar credit quality in other regions.
     

     

  • Equity market rotations made a sizeable impact on performance over the last two years, and we fully expect that trend to continue in 2024. The absence of the US mega caps in the convertible universe has been detrimental for convertible bonds in relative terms. Still, it could become a source of outperformance in 2024 considering the high multiples that the market currently ascribes to those companies. Disappointing earnings reports in the coming seasons could lead to a sharp re-valuation. 


    Styles

    The value bucket is currently particularly overweight in the convertible bond universe compared to global equity indices such as the MSCI World. Value companies tend to outperform in the months following the start of a bear steepening regime, or when yields rise more for longer-term bonds than shorter-term paper. 

    However, lower rates are eventually necessary for rate-sensitive sectors such as renewables and bond proxies (REITS, telecoms, high dividend stocks and consumer staples) to shine, in our view. These sectors are being penalised by the comparison with yields available in fixed income, which look increasingly attractive. If long-term rates stabilise, utilities should rebound after the recent sell-off.

    Figure 1. Style breakdown by universe
     


    Source LOIM & MSCI. Weightings are subject to change. For illustrative purposes only.
     

    Investment themes

    If our base-case scenario materialises, the following investment themes could perform well in 2024.

    • Semiconductor companies should benefit from a new inventory cycle and the secular support of the ever-growing digitalisation of the economy
    • Cybersecurity is considered mission-critical and is still a priority for IT decision-makers. There is also on-going industry consolidation
    • Cloud spending has slowed somewhat due to recent macro uncertainty, but it has likely bottomed as highlighted by recent positive results from Microsoft and Amazon1
    • Higher interest rates have impacted the profitability of new projects for non-residential solar and wind suppliers, leading to a sharp market correction. Sentiment remains poor, but the longer-term growth story has not structurally changed. Government plans, new or existing, are likely to continue to boost wind and solar energy providers
    • Exposure to the defence sector will be supported by the tense geopolitical environment, which could lead to increased global defence procurement budgets


    1 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.
     

  • Convertible bonds are likely to benefit from specific dynamics in 2024 linked to bond supply, valuations and an expected uptick in volatility.

    Convertible and high yield issuers will need to refinance over the next two years. We expect this to have a positive impact on the asset class. We forecast an increase in convertible bond issuance in 2024 as both repeat and new issuers will be attracted to paying the lower coupons that are possible on convertible debt compared to high-yield debt, especially in the context of structurally high rates. For investors, the primary market has historically been a source of outperformance, and this is especially true currently, when valuations are inexpensive.

    After a disappointing year in 2023, we expect volatility to be a performance driver for convertible bond investors in 2024. Equity market volatility will be supported by geopolitical risks and lofty expectations for 2024 EPS growth that could be at risk if global GDP slows. Generally speaking, equity volatility tends to rise later in the economic cycle, as shown in figure 2.

    Figure 2. Equity volatility tends to dip after the last interest rate rise in the cycle and rise later in the cycle.
     


    Source: LOIM, BNP Paribas, Bloomberg LLP. VIX – Chicago Board Options Exchange Volatility Index. For illustrative purposes only.

    Asia-Pacific and Japanese convertible bonds are particularly inexpensive relative to current realised vol (figure 3). Hedge fund positioning in the asset class is currently light, with leverage at historical lows. This could become a tailwind if arbitrage opportunities tempt these investors to increase leverage and buy back into convertibles. We could see a more balanced investor in/outflow ratio as average coupons become increasingly attractive, and issuance attracts fresh money. 

    Figure 3. Convertibles are inexpensive relative to current levels of realised volatility 


    Source: LOIM and Bloomberg LLP. For illustrative purposes only. As of 31 October 2023.

     

  • A supply/demand imbalance in US Treasuries has been the main driver of the recent episode of yield curve bear steepening. Considering the high level of global fiscal deficits and the upcoming wall of corporate refinancing, it is hard to gauge whether the repricing of the term premium is over. We expect tighter financial conditions to help central banks combat inflation and are in the camp of investors who believe that short rates in the US/Europe have peaked for now.

    Most convertible bonds have low direct duration of around 2-3 years, limiting the impact of rate moves. However, the ‘indirect duration’ of the asset class could lead to outperformance if rates fall.  The indirect duration of convertibles refers to the effect of rate moves on the performance of unfunded growth companies. In convertibles, the high(er) proportion of growth companies and bond proxies should contribute positively if long rates stabilise. This could also be true in a more negative macro scenario, where central banks have to cut rates to avoid a recession. 
     

    We prefer longer duration for investment-grade convertible bonds vs. shorter duration for high-yield issuers. Clarity about the outlook for credit quality is important for lower-rated issuers. In investment grade, however, typically sounder fundamentals make us more comfortable with longer duration.

     

  • In addition to our base-case scenario, we also consider two alternative scenarios.

    A recession finally materialises after being forecast for most of 2023, driven by rising geopolitical risk and:

    • Tighter financial conditions, as the ongoing supply-demand imbalance in government debt markets could drain liquidity further and add to pressure on rates. Small and medium-sized companies could be most at risk, leading to a negative spiral of lay-offs, a decline in consumer confidence and thus a drop in consumption
    • Higher energy prices (especially in Europe), the resumption of student loan repayments in November and industrial action in the US could squeeze household consumption in 2024
       

    In a recession scenario, EPS expectations of 10% growth look high for 2024 if global growth slows and pricing power fades. 

    Corporate margins will be increasingly impacted by higher financing costs. The refinancing calendar will be key in our view, even if rates rise further. 

    Companies with long duration assets matched by long maturity debt and positive maintenance cashflow, will be less at risk, such as utilities, telecoms, big pharma. This could be partially offset by higher earnings multiples if central banks are forced to cut rates sooner than expected. 


    A broad market rebound is a less obvious scenario, but the possibility should not be excluded. Equity markets have become more oversold than overbought recently and investor positioning is light. We consider the probability of a rebound to be higher if:

    • The labour market remains tight, and supports consumption, but upward wage pressure remains limited
    • Equilibrium returns to the supply and demand of government and corporate debt. Higher rates, the result of the current imbalance, have driven the recent equity market correction
    • There is greater stimulus in China aimed at boosting consumer spending and stabilising the real estate sector, which could boost GDP growth and sentiment
    • Geopolitical risks abate
    • Fiscal support in the US and Europe provides a floor for growth and a boost for capex
       

    If there is a rebound, cyclicals could do well while defensive, rate sensitive issuers – such as bond proxies, utilities, telecoms, real estate – may underperform.



    Table 1. How different scenarios could impact stocks, rates, credit spreads and volatility

    Scenario

    Expected
    underlying stock
    performance

    Rates
    assumption1

    Expected credit
    spread move2

    Forecast change
    in volatility

    Recession

    -15%

    -1.5%

    +30%

    +7.0%

    Comments
    • Stock move based on average MSCI World performance during a global recession
    • Rates move based on implied rate cuts by the Federal Reserve and European Central
      Bank of - 0.5% to factor-in a worst macro scenario (as of 01/11/23)
    • Credit spread shift based on the Markit iTRAXX Xover widening back to 650
    • Volatility move based on average convertible bond implied volatility from 2020 – to
      mid-2022

    Base-case
    scenario

    5%

    -0.5%

    0%

    +2.5%

    Comments
    • Stock move based on global EPS growth in the 5-10% range
    • Rates move based on implied rates (as of 01/11/23) + 0.5% higher
    • Volatility move based on convergence to global convertibles universe fair value
    • No change in credit spreads

    Rebound

    10%

    0.5%

    -20%

    +2.5%

    Comments
    • Stock move based on average MSCI World performance during a period of recovery
    • Rates move based on bear steepening driven by higher inflation expectations
    • Volatility move based on convergence to global convertibles universe fair
      value. If the equity market recovery is gradual, lower realised market volatility will be
      offset by investor demand
    • Credit spread shift based on the Markit iTRAXX Xover tightening to 350

    1 Long term government yield curve shift in %    
    2 % change in existing spreads. These scenarios are based on LOIM analysis. For illustrative purposes only. As of 31 October 2023.

     

    Supportive dynamics
    If our base-case scenario plays out, then convertible bonds will benefit from supportive, asset-class specific dynamics in 2024. In this case, we would expect the primary market, indirect duration, style bias, thematic positioning and regional weightings to have a positive impact on potential performance. 

  • Convertible bond strategies could be more defensive than a 40/60 multi-asset strategy in a recessionary scenario, while offering similar potential upside in the event of a market rebound. A 40/60 strategy would perform well under our base case scenario because of its higher duration, but the risk of it underperforming due to the dominance of the mega-cap stocks in equity indices remains. The figures in table 2 do not incorporate the additional potential performance from investor-friendly new convertible issuance. Additionally, they do not factor in the higher proportion of bond proxies and growth names, which we expect to outperform if rates remain unchanged or begin to fall.

    Table 2. Estimated performance in 2024 by scenario for a balanced global convertible bond strategy, the Refinitiv Global Focus Benchmark index and a 40/60 strategy

    Scenario

    Global convertible
    bond

    Global Focus
    Index

    40/60 Strategy1

    Recession

    -0.2%

    -0.4%

    -1.5%

    Base case scenario

    5.5%

    5.1%

    6.6%

    Rebound

    6.3%

    5.8%

    6.4%

    1 Source: LOIM. The 40/60 strategy is 40% MSCI World EUR Hedged and 60% Bloomberg Credit Corporates EUR Hedged. For illustrative purposes only. Performance is an estimate of future performance based on current market conditions and is not an exact indicator. Performance varies depending on market performance and how long the strategy is held. There can be no guarantee that a target objective will be reached or performance achieved. Return estimate shown is net of fees and refers to a balanced convertible bond strategy. This document has been prepared by LOIM employees who are encouraged to raise assets for their strategy and may have a conflict of interest.

    The following pricing assumptions were made:

     

    Global convertible bond

    MSCI

    Bloomberg Credit Corp.

    Dividends

    N/A

    2.2%

    N/A

    Modified yield or YTW

    2.2%

    N/A

    6.3%

    Annual FX hedge cost

    -0.72%

    -0.94%

    -0.94%

    Rate sensitivity

    -2.1%

    N/A

    -5.6%

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