Why convertibles make sense for credit investors

Convertibles acting like fixed income

The sharp and prolonged sell-off in global equity and credit markets in the first half of 2022 has reduced the equity sensitivity of a large part of the convertible bond universe. This has created a rare investment opportunity for fixed-income investors seeking a fixed-rate of return.

Historically, equity exposure has been an important performance driver for the asset class, but if equities disappoint, credit can still offer strong return potential. In our view, this is an environment where credit can produce equity-type returns. Many convertible bonds from solid borrowers are currently trading at their bond floor (or minimum theoretical value) due to the equity sell-off. This means convertibles are functioning as a traditional fixed-income instrument, yet can still offer upside potential via the embedded equity option.

Parallels with 2008 disconnect

The Lehman Brothers bankruptcy in late 2008 led to a number of specific conditions to which there are parallels today. Then, equities fell and credit spreads widened; more importantly, as much as 70% of the convertible universe was held by hedge fund and proprietary trading desks who became forced sellers after banks and prime brokers withdrew funding and cut leverage. These holders sold into a plunging market and even the higher quality names in the universe became dislocated and unloved.

The traditional marginal equity buyers were not ready to step in, but gradually fixed-income buyers came to understand the attributes of the asset class. Convertibles usually rank pari passu with an issuer’s straight debt from the same ratings bucket, thus the pricing disconnect between convertibles and the equivalent straight bonds was structurally unjustified and technically compelling.

The backdrop today presents similarly compelling opportunities for fixed income investors. In fact, some areas of fragility from 2008 have improved: bank and company balance sheets are leaner and cleaner, liquidity is better and there are fewer hedge fund holders of the asset class.

Dislocated and overlooked

Current market timing appears propitious for convertibles due to the technical configuration of the asset class: a significant part of the universe is dislocated and overlooked. The shift in Federal Reserve policy has caused an indiscriminate sell-off in growth names, including convertible bonds issued when share prices were significantly higher. Yet many of these companies are profitable and either have no immediate refinancing needs or have sufficient access to bank or capital-market liquidity.

For instance, close to 50% of global convertible-bond issuers have no other publicly traded debt on their balance sheet, offering diversification for clients already invested in fixed income. More than 60% of outstanding convertibles are not due to mature until 2025, meaning such borrowers do not need to refinance imminently in the current challenging context.

Source: Bank of America Merrill Lynch.

A boost from duration and M&A

Other factors are also at play making the asset class compelling, from duration considerations to the surge in M&A and buy-backs, in our opinion.

In the US and the Eurozone, rate rises are being front-loaded as central banks deploy all available monetary policy tools in an effort to curb inflation. Convertible bonds tend to be less exposed to inflation and interest rates than traditional bond instruments. They typically have a shorter maturity than the average standard corporate credit. The asset class also has lower indirect duration¹ than in the past 2 years (as many unprofitable high-growth names have gradually left the benchmark), leaving convertibles less vulnerable to rate rises.

Global M&A activity has surged this year. Buy-outs can be an important incremental source of returns - in the event of a takeover, convertibles often benefit from an uplift due to prospectus terms. A premium offer can cause the share price to rise, increasing the value of the underlying basket, while ratchet features can enhance returns further by adding extra shares to the exchange property.

Issuer buy-backs can also contribute to performance and be an effective use of balance sheet capacity. We are seeing numerous premium-to-trading price tender offers for outstanding convertibles, especially from Asian issuers keen to benefit from prevailing low valuation levels.

Yield-to-maturity funds

In 2009, a number of yield-to-maturity convertible funds were launched. These had fixed maturities and so-called “free” equity options (i.e. the convertible optionality was completely out-of-the-money). The technicals of the asset class look similar today. To quantify whether a portfolio of out-of-the-money convertible bonds could be an attractive investment, it’s important to understand how convertibles can generate returns if equity markets take time to recover.

The main performance drivers of convertibles are:

• the pull to par from the current market price
• the return of convexity² (or the increased value of the equity option embedded in the convertible) in a rising equity market
• the coupon stream.

Typically as credit spreads tighten and equities rise, the first two performance drivers act in concert to generate returns. Even in the current uncertain macro setting, it is still possible to calculate the potential return over a given timeframe for convertibles trading on their bond floor. When the underlying share drops, a convertible looks like a classic fixed-income instrument.

As managers sell, this causes a discount between the market price and the intrinsic value, creating a market opportunity for credit investors seeking yield. Currently, we calculate that some 15% of the main global benchmark index is trading below the bond floor with a “free” option, while 20% trades within 5% of bond value, so with less than 5% equity risk.

Volatility benefits

The current market is also interesting from a volatility perspective. Historically, coupons on convertibles have been lower than those on straight debt, to take the incremental upside from the equity optionality into account. Convertible holders effectively paid for convexity by receiving a lower coupon.

Today, not only is volatility still healthy for the value of the embedded options but the yield pick-up is paying investors for owning a convex instrument which has eventual equity upside potential. Put differently, the asymmetry of convertibles means that they could eventually benefit from equity upside potential, yet this is not reflected in the price.

As we close the first half of 2022, where performance has been negative for traditional long-only asset classes, convertibles have nonetheless resisted well. Our high conviction strategy - of adopting a defensive stance, carefully managing equity sensitivity, keeping a lower duration than the universe and being disciplined in respecting entry and exit points - has added resilience to our portfolios.

If 75bps is to be the new 25bps through the summer months and terminal rates are revised up in both the US and Eurozone, we firmly believe the time is right to revisit a global convertible bond buy-to-hold strategy.

Sources

[1] Indirect duration refers to unprofitable companies borrowing to finance future growth. They are particularly sensitive to rate rises.

[2] Convexity is also known as an asymmetric return profile offering upside participation as well as downside protection.

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