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Wednesday, 25 April 2018

Convertible Bonds – A Renaissance

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  • Martin Haycock, senior partner, Fisch Asset Management

Many investors are presently conflicted. The macroeconomic environment supports a positive view on risk assets with growth across much of the world. Yet valuations in debt and equity markets are sufficiently high that investors are nervous about corrections.

February’s correction was a stark reminder of the need to be mindful of downside risks to markets – and then they fell further in March. The huge growth in passive ETF investment across asset classes has additionally made investors nervous as they make assets vulnerable to technical sell-offs.

Convertible bonds offer investors a means to reconcile their conflicting feelings about equity markets. The combination of the features of a corporate bond together with an option to convert into shares of the issuer leads to an asymmetric risk-return profile. They give exposure to further upside in equity markets, while offering downside protection thanks to the ‘bond floor’.

So much for the theory, but what has happened in practice?

In January 2018, global equities rallied hard, the MSCI Global Index gaining over 5% before the end of the month. Balanced convertible bonds in the Thomson Reuters Global Focus CB Index participated in this upside, gaining 2.76%, a capture rate of 53%. The more equity-sensitive convertibles within the Thomson Reuters Global CB Index captured 69% of the upside of the MSCI.

When markets subsequently fell, the defensive qualities of convertible bonds came into play. The drawdown of the MSCI Global was 8.3% from peak to February trough; for balanced convertibles it was less than half that size.

The “impeccable behaviour” of the CB asset class in the rally and correction of early 2018 can perfectly be illustrated with US cloud services provider ServiceNow.

The company has increased its revenues and client base consistently, with its only debt being two convertible bonds. On February 8, the stock fell 10%, while the longer-dated 2022 convertible fell less than 6% despite having an equity exposure of 66%, showing the benefit of an investment in the convertibles as a more defensive way to play the equity upside.

Meanwhile, a short-dated convertible from internet content delivery company Akamai Technologies shows how defensive, implied investment-grade quality convertibles can support performance, falling barely 1% while the stock fell nearly 8%.

At a time when 10-year government bond yields are 0.48% for Bunds and 2.75% for Treasuries and seemingly heading upwards, many investors have looked to emerging market and high-yield corporate bonds for greater returns. While the running yield on these asset classes positions them well against other asset classes, year-to-date performance in US dollars is below that of convertibles, owing in large part to rising risk-free rates.

Convertible bonds are much less sensitive to interest rate rises than other forms of bond. This is in part owing to average maturities being around four years, but critically because the option component of a CB typically becomes more valuable when rates rise.

 

Active not passive

A key feature of the global convertible bond market is that it has extremely low levels of investment via passive ETF products, stemming from the complexities of the product and subtle differences between regional markets. This greatly reduces the risk of a valuation collapse following outflows from ETFs, a risk ever-present in many other asset classes.

The CB investor base contains a mixture of specialist long-only CB funds together with hedge funds and equity and fixed income investors operating at the fringes of the market. Hedge funds are extremely helpful, as their investment strategies mean they often buy positions that are less appealing to long-only investors, providing liquidity and giving issuers structural flexibility. Further, hedge fund leverage levels grow and shrink over time based on the opportunity set present at any time, providing a natural cushioning effect on valuations.

The lifeblood of the convertible bond asset class is the flow of new issues coming to market. January 2018 brought a plethora of new deals, in particular from Asia ex-Japan, which saw its second largest monthly issuance volume of all time with US$6.8bn of new paper.

Property companies China Evergrande (US$2.3bn) and Country Garden (US$2bn) were the largest issuers globally. Also noteworthy was the range of issue structures, including exchangeable bonds, floating-rate bank capital convertibles, mandatory convertibles, and a wide range of maturities, all going to show the diversity of uses to which convertibles can be used to solve corporate financing needs.

While bankers might wish issuance was higher, particularly in EMEA where volume is down 40% in the first quarter 2018 versus 2017, there has been sufficient new paper and structures on a global basis to provide opportunities for investors without a sharp increase in paper negatively impacting valuations.

A rising interest rate environment is positive for new issuance as issuers are more attracted to using the equity option to cut the cost of financing versus straight debt. At the same time, companies are able not only to monetise recent increases in their stock volatility but also to secure conversion prices well above all-time highs.

With competing emotional forces driving investors’ thoughts about asset allocation, it is no surprise that Fisch Asset Management is seeing strong and growing levels of interest in convertible bonds from clients. The asset class has delivered on its promises in the early part of 2018, with a renaissance underway as companies and investors see the benefits of this unique asset class.

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