We are all aware that today we are riding along in a different macro environment, but surely the policy bonanza has to end at some point. The FT described it as the moment when the lights come back on and the music fades, and you still see people on the dance floor. We are looking at less-than-ideal returns for the fixed income market in the near future.
Convertible bonds could be one solution given this backdrop. Their combination of cheap valuations and equity exposure can provide a hugely asymmetrical return profile in a rising interest rate environment.
Convertible bonds are corporate bonds, so they have a coupon, a maturity date, and a maturity price, just like any other bond. The only difference is that you as an investor can exchange them for a fixed amount of shares (agreed at issue) instead of waiting for redemption. The value of this packet of shares you would receive on conversion is known as parity. If the share price moves higher, this value, or parity, could well be worth more than the bond’s face value, and therefore would warrant conversion. If the share price falls, and parity remains below the face value of the bonds, then you wait for redemption and collect the coupons, as with any other bond.
There are three possible outcomes at maturity:
Options 2 and 3 are identical to any other bond investment, except that you receive a slightly smaller yield on the convertible. In the event of default, in the case of an exchangeable (different issuer than underlying equity) you might get away with parity anyway, if the stock was ring-fenced and not swallowed up in the issuer’s bankruptcy. Option 1 is where the fun begins. This optionality is not present at all in the regular bond market, and is what will protect us in the coming months if we do see rising interest rates.
The yield sacrifice you encounter in the convertible bond market is not excessive if you choose well, and will allow you to include the asset class in your fixed income portfolio without too much of a dent. Understandably there will be more price volatility because of the equity sensitivity, but the capital risk will be the same as any other corporate bond. The equity optionality also provides for much lower interest rate sensitivity. The positive equity correlation to higher rates also provides for upside in convertible bonds. While regular fixed income assets will suffer when rates rise, convertible bonds will have exposure to rising equity prices, offsetting the downside in duration.
We have highlighted different periods in recent history of major interest rate moves in order to compare equity, fixed income and convertible bond performance, and to identify any equity correlation mentioned above. You can see the performance of the three asset classes during these periods in the chart below.
The obvious standout is the equity market. In all these moments of major interest rate moves the equity market has been positive, in some cases spectacularly so. Although this is not immediately intuitive, one can imagine interest rates start moving higher on the back of a strong macroeconomic backdrop, leading to strong earnings, well before the added pinch to the cost of money starts eroding.
Much more intuitive, though, is the suffering of the fixed income world as a result of higher interest rates. Anything other than the shortest of durations will be marked lower. The convertible bond equity exposure is rather obvious in the data above, providing ample upside even when the bond market is at its worst. And let us not forget, they are carrying exactly the same capital risk of their cousins, only with the added benefit of offering equity upside. If you believe interest rates are going to move higher, you want to own convertible bonds in your fixed income portfolio. In terms of valuations, convertible bonds have a life of their own. The fair value of a convertible bond is based on the credit spread used to value the bond component, and the volatility used to compute the embedded option component. Volatility as measured by the VIX index is currently at historical lows. In the event of an equity market correction we would likely see a sharp rise in volatility, which would push convertible bond valuations higher from their relatively cheap levels today but they would go down less than they would on the same valuation, dampening the fall. If, however, volatility remains low, convertibles should benefit from further equity upside in a difficult market for traditional fixed income. Not exactly win-win, but certainly win-lose less.
We believe this is a truly compelling time to invest in the asset class for a number of reasons. First, with interest rates remaining depressed, convertibles provide massive convexity (the price depreciation associated with rising interest rates is much smaller than the extent of appreciation triggered by a fall in interest rates of the same magnitude). Second, valuations are cheap and this combination of cheap valuations and convexity makes a compelling case due to the combination of considerable upside potential and the high level of protection that investors enjoy (a positive asymmetric return profile).