30 March 2020
The sizeable market dislocations of recent weeks have resulted in some anomalous valuations between the convertible and traditional bonds of quality companies. GAM Investments' Jonathan Stanford discusses why this presents a rare opportunity for investors.
As we have seen multiple times in the past, catastrophic market conditions often present rare opportunities. As we near the end of March, it is our view that most of the pandemic-related damage has been done, but the dust still needs to settle. During this challenging time, we have seen investors move to cash on a significant scale. This has been particularly damaging for the credit market, as we have seen mass redemptions across the spectrum of credit funds and ETFs. These redemptions have consequently forced mangers to sell what they can, rather than what they would like to sell. What they have been able to sell has generally been high grade credit with shorter maturities, solid balance sheets and no impending re-financing needs, notwithstanding the human tragedy behind this sell off, as investors we have to consider the opportunities such forced selling opens up.
We currently find bonds offering substantial yields, while backed by solid balance sheets. Convertible bonds are often the first to capitulate in such circumstances, largely because they do not fit into any particular bucket and their sale can therefore be easier to justify. We witnessed this in 2008, and again in Europe in 2011, where massive price dislocations arose between traditional bonds and their convertible cousins. Negative basis scenarios – where the yield on convertible bonds exceeds the yield on equivalent straight bonds – were abundant during these two sell offs and seem to have reappeared currently courtesy of the coronavirus pandemic. We are in little doubt that the global shutdown is funnelling us all into a rather deep recession, but we are now identifying many attractively valued bonds issued by companies that have balance sheets that can weather this and many other storms along the way. And quite frankly, we believe the yields now on offer more than compensate for the risks going forward. Only a couple of months ago, the world was desperately hunting for yield, willing to lend money to companies for low, or even negative, yields. Yet, today the market does not seem to want to make a bid on these same bonds with yields at 7%, 8% or 9%.
The pricing madness has not avoided the investment grade world either, particularly in the convertible bond asset class. We have observed lots of scenarios which, to us, seem unexplainable. For example, the yield difference between the American Movil / KPN EUR convertible and the 3% American Movil traditional bond is currently 8.38% on the bid and 4.76% on the offer (source: Bloomberg as at 26 March 2020). That is an A3/A rated bond maturing in two months at +500 bps spread, while the traditional form of this bond is trading at a yield of 0.90/0.60%, for the same level of senior unsecured seniority and a maturity that is 1.5 years longer. This begs the question, why is the convertible bond market discounting such a large yield while it runs an estimated USD 3.5 billion free cash flow for next year?
We have found numerous other such anomalies among quality companies. Italian electric component provider Prysmian is another interesting example of a quality company with a healthy seeming balance sheet and overall financial credentials, but who has been disproportionately caught up in the sell off. In this instance, not only are its convertible bonds more attractively valued than its traditional bonds, but the convertible attributes of these assets into stock are illustrated. At present, parity – the value of the underlying shares into which you can convert – is still 47% of par, despite a 30% plunge in the value of the stock.
The list could go on and we have not yet considered the attractively valued convertibles that do not have a direct traditional bond for comparison purposes, but nonetheless have solid balance sheets and trade on massively discounted credit spreads. While we would not dispute the argument that the looming recession will in all likelihood dent the earnings capacity of these companies, but we believe the probability of default among these companies is rather slim based on their current solidity.
The credit market is clearly pricing in a rather drastic scenario in the very short term, but we believe it is compensating investors with wider-than-fair yields. As the dust settles, we believe these prices will tighten and converge to their fair values, as they always tend to do. This suggests the market is entering a period of rare opportunity in terms of valuation, given post sell off excessive discounting has generally proven to be profitable in the past. Of course we could see continued pressure on the markets before we start to see a substantial retracement, but we are confident in the financial position of many of these issuers and believe the yield and price dislocation offered in these instances will compensate market risks. In our view, we are now at a considerable opportunity to buy discounted assets at valuations that quite frankly do not come around very often.
advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The companies listed were selected from the universe of companies covered by the portfolio managers to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.