Tarek Saber, Head of Convertible Bonds
The 150-year old CB asset class offers investors an opportunity to diversify their portfolios and improve risk-adjusted returns.
Historically, CBs have performed very well in comparison to other asset classes: they have delivered equity-like returns with less volatility throughout multiple economic cycles. The embedded equity call option increases the value of the CB when the share price goes up while the bond component protects investor’s capital in a downturn.
The asymmetrical return profile (convexity) is the most distinctive feature of the CB asset class that adds diversification and efficiency to investors’ portfolios – it is the reason why CBs should be considered a part of the strategic asset allocation. Further diversification benefits are brought by the unique credit exposure mix as many of the CB issuers do not have any other tradeable debt.
CBs also have short effective duration and are not so sensitive to rising interest rates because the duration of the bond component is decreased by the attached equity option.
According to Saber, “It is important that CB investors be selective in order to unlock the full benefits of the asset class and receive the optimal equity return participation and downside protection.”
CB performance versus major asset classes
CBs have historically provided equity-like returns with lower volatility and downside protection.
Note: 1997-2018, 1997=$100. Unhedged data until December 2001, USD hedged thereafter. Source: Bloomberg, Thomson Reuters, ICE BofAML, Data as of July 2018.
CBs in a rising interest rate environment
The convertible asset class tends to perform rather well in a rising interest rate environment. In the previous six cycles of rising rates that took place in the Thomson Reuters Global Convertible Bond Index (since end of 1997), the annualised return of the index was about 20%.
Monetary tightening usually coincides with a growing economy at full employment which drives corporate earnings up so equity markets rise and convertible bonds benefit.
The latest episode of rising interest rates started in late 2015 in the US and convertible bonds have posted strong returns relative to other asset classes but also in absolute terms.
Rising rates can be advantageous for CBs as they usually trigger more new issuance, expanding the opportunity set for investors.
In 2018 the CB investment universe has been benefitting from increased new issuances. In the first six months over $70 billion in new CBs were issued globally – the highest volume in over a decade.
The phenomenon is largely attributed to the rising interest rates in the US as majority of the new US dollar CBs were brought to the market to refinance high yield and investment grade bonds. In fact, US convertible issuance totalled about 36% of US high yield issuance year-to-date compared to 16% in 2017.
Notably, over 50% of the new issues were first time issuers, which is a record high and shows the significant expansion of the investment universe.
Ivan Nikolov, senior portfolio manager, convertible bonds expects global issuance should remain strong going forward, driven by the US and Europe where a similar trend is expected to emerge following the end of the ECB bond buying programme.
CBs in a low yield environment
CB returns are primarily driven by underlying equities followed by spreads and volatility. With potential equity-like upside and bond floor downside, CBs are suitable when economic growth is subdued and there is an absence of a strong market trend.
Japan is an example of a long-lasting low yield environment where bond returns have been very low and equities both volatile and uncertain. CBs navigated through this market well and were the best performing asset class among equities and bonds for most of the period since the early 2000s.
CBs have a place in the asset allocation conundrum
Nobody knows for sure where markets will be heading tomorrow. Economic benchmarks in the developed world remain consistent with positive growth while the escalation of protectionism, changes in legislation and emerging markets instability are the dominant sources of volatility.
Convertibles are a solution to bring investors closer to their optimal equity/credit mix. With asymmetrical returns and low interest rate duration, CBs are ideally positioned to efficiently navigate markets showing more divergence than previously seen.
Ivan Nikolov is senior portfolio manager and Tarek Saber is head of convertible strategies at NN IP.