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Convertible bonds: overlooked and unloved?

7 November 2018

Convertible bonds have been an unloved asset of late, but in the context of mid to long-term asset allocation GAM Investment's Jonathan Stanford believes they offer a clear solution for dampening equity volatility while providing fixed income distribution.

There are typically two kinds of investors who look at convertible bonds (CBs): those who view the asset class as a lower risk equity instrument and those who view the asset class as a volatile bond investment. In our view, they encompass all of that and much more, and are highly overlooked by the average market participant. This leads to a lot of head scratching on our part, as we cannot understand why CBs are not more commonly present in all asset allocation models. Numerous empirical studies are out there to look at demonstrating their long-term effectiveness, yet investors shy away, probably put off by the small size, relatively low liquidity and sheer complexity of the valuation. The good news is that all this creates mispricing opportunities for those of us willing to have a look.

CBs have performed very much in line with the overall equity markets on a mid to long-term basis. This is contrary to the average perception that they only participate in 60-70% of the upside and 30-40% of the downside, which I believe is a very short-term view. There are numerous moving parts in CB valuations and we have observed that the combination of these can produce remarkably equity-like performance over a longer period.

Chart 1: Global equities versus global convertibles

Source: Bloomberg. UBS Thomson Reuters Global Focus Convertible Index (USD) – MSCI World Index (USD). Data range: 01/01/1994 – 22/10/2018.

Past performance is not an indicator of future performance and current or future trends. Indices cannot be purchased directly.

Global equity markets have been marching along quite impressively post the 2008 credit crisis, mostly thanks to a US market which has posted significant gains and pushed some valuations to questionable sustainability, in our view. CBs have been close to matching this long-term performance, offering very similar returns with substantially less volatility. Chart 2 shows the realised volatility of global CBs (on a 360 day basis) is typically half that of global equities.

Chart 2: CB volatility lower than equities

Chart 2: Convertible bonds

Source: Bloomberg. UBS Thomson Reuters Global Focus Convertible Index (USD) – MSCI World Index (USD). Data range: 15/03/1995 – 22/10/2018.

Past performance is not an indicator of future performance and current or future trends. Indices cannot be purchased directly.

When equity market downturns happen, CBs have the potential to outperform quite considerably thanks to their fixed income characteristics, such as capital protection, maturity and coupon stream. Since the credit crisis, which put a strain on the very essence of the fixed income component, CBs traded back to their redemption prices and beyond within 12 to 18 months after the collapse. It took comparable equity markets some four to five years to achieve their previous highs again. Therefore, the concept of a duration asset proved very useful even for equity investors.

Generally, CBs are also high up the capital structure compared to equity. Although some subordinated debt and preferred structures exist, most CBs are issued as senior unsecured debt and therefore sit just behind bank loans and secured debt in the event of default. Common equity generally sits last in line. This has come in useful on many occasions as CB holders have had a good seat at the table when it came to restructuring balance sheets, or issuing huge equity capital at the expense of existing shareholders.

Illustration 1: Corporate Capital Structure

For illustrative purposes only

CB issuers have learned, over the years, to appeal more to equity investors by introducing interesting wording in the issues’ prospectuses. Provisions for dividend protection and for change of control protection are now common practice and allow CBs to match equities in various corporate actions. In the current environment of extremely low interest rates and relatively high dividend yields it has been important to offer income pass-through while offering coupons, albeit small ones.

As an equity investor, what is not to like about comparable returns, half the volatility, senior ranking with capital protection?

Bond investors have been enjoying a remarkable few decades. Since the high in September 1981, US treasury yields have come down from 15% to 3% (to September 2018). There were plenty of ups and downs on the way, but on average, that’s a 0.32% decline per annum. If we assume, for arguments sake that we invested in an average duration of five years with 2.25% capital gain, plus an average coupon of 5.25% for a total of 7.5% returns annually, which simply rolled on into equivalent 5 year bonds. This would not have been bad at all, considering the S&P500 Total Return index returned 11.9% annually over the same period, and was certainly better than average inflation. We would have achieved positive real returns.

Yet looking forward, things do not look so simple anymore. Current yields in 5 year US treasury bonds are just shy of 3% and headline inflation is 2.3% (with a Federal Reserve (Fed) target of 2%). In Europe things look even worse. EUR 5 year yields are -0.2% with inflation at 2.2%. We have been living with negative real returns since April 2010. It is not hard to believe interest rates will need to trend substantially higher in order to normalise in the foreseeable future. We will leave it to the macro strategists to call the short term moves, but in the medium to long term it seems quite clear to us which way we are going – it will be hard to achieve the bond returns we have witnessed in our recent past.

Now turning to convertible bonds. For a fixed income investor who wants to maintain capital preservation and some sort of yield, we believe CBs make a whole lot of sense. Let us look at the basics: CBs have a fixed maturity, a coupon (albeit a small one) and a redemption price anywhere between a minimum of par and a maximum of equity parity on the day of maturity. As CBs are convertible into a fixed amount of shares, these may well be worth a lot more than 100% of face value when the time comes. On the other hand, the minimum redemption price is par, so you have the same capital risk as any other bond. So you own a bond and, if you get lucky with the underlying equity, you may receive substantial equity-like returns and, if you get it wrong or the market does not cooperate, you should get your money back plus coupon. The only price to pay for this luxury is lower coupons and higher price volatility. As mentioned above, CBs are generally issued as senior unsecured debt, so you are also equal in the capital structure. Of course there are many variations on the theme, but this is the recent norm.

Issuers also enjoy the benefits of the CB market, as they can borrow at lower cost of capital, and if conversion does occur, dilution will be at a substantial premium than when issued. Companies with solid balance sheets might also take advantage of the scarcity value in quality CBs that will be issued at a relatively expensive level and purchase long-dated call options more cheaply in the market to offset future dilution. This spread gain on the options essentially allows these companies to issue the equivalent of straight bonds at a lower cost of capital. We expect interest should rise in the foreseeable future, as more and more companies seek the attractiveness of the CB market to raise their capital needs.

Because of their embedded equity optionality, CBs have had the habit of performing rather well in times of rising interest rates. This is because these normally coincide with expanding macro-economic output and therefore often correlate to higher stock markets. In chart 3, eight of the most recent significant moves in interest rates are highlighted, including the on-going move higher that started in 2016. This also coincides with the bottom in both EUR and GBP rates.

Chart 3: USD 5y interest rates

Source: Bloomberg. Data range: 01/01/1994 – 22/10/2018.

Past performance is not an indicator of future performance and current or future trends.

In all of these periods it is interesting to note that the CB market significantly outperformed the bond market (as shown in Chart 4) and that in only one of these periods were CB returns actually negative.

Chart 4: Outperformance of CBs versus bonds

Source: Bloomberg. UBS Thomson Reuters Global Focus Convertible Index (USD) – MSCI World Index (USD) - Bloomberg Barclays Global Aggregate Bond Index.

Past performance is not an indicator of future performance and current or future trends. Indices cannot be purchased directly.

For the fixed income investor, we have observed that a solid allocation to CBs has provided an opportunity to mitigate the negative duration effect of rising interest rates while maintaining the same capital risk. The yield sacrifice is often smaller than one might think and the overall effect on a large bond portfolio is minimal.

As a fixed income investor, what is not to like about greater diversification, equal capital risk and seniority, positive equity correlation, shorter duration, while still generating positive yields? All things equal, it seems to us like an alternative way to aim to generate positive real returns going forward, without abandoning fixed income assets.

Even so, mark-to-market volatility, complexity in pricing and an absence of liquidity premium, are shying investors away from an asset class that can actually offer great potential. We have often witnessed a marked over-reaction to events that take place in the CB market. This is mostly because of the relatively small size and breadth of the market and because of the scarce understanding of the technical complexities governing valuations. We believe these reactions are often linked to over-benchmarking and herd-flows rather than sound fundamental reasoning. This creates opportunities thanks to the inefficiency of the market. Testament to this was the ample negative basis present in the CB market during the credit crisis in 2008, where you could easily find convertibles yielding far more than the straight bonds of same seniority from the same issuer. These “forgotten” equity options offered huge opportunities, on top of the higher yields.

In today’s shaky equity market environment, we believe convertibles are very attractive as a means to dampen volatility, especially as we have not seen substantial credit deterioration among issuers. For example, during the tech bubble implosion in 1999-2002, when the sell-off was caused primarily by an overheated equity market, the credit market held up pretty well. The convertible bond market did suffer to some extent, but the bond floors offered by the asset class were strong and mitigated losses for equity investors.

For fixed income investors, we believe the recent drawdown in CB prices offers an attractive opportunity to enter the market with reasonably solid yields of around 3.0% average yield to maturity. To us, this seems like a very comfortable level to take exposure, without adding too much “equity risk”. There are out-of-benchmark issues that have been neglected by the market offering interesting opportunities going forward and the recent sell-off has accentuated these profiles. For example, bonds in a gold mining company are trading in the low 90s offering a 5.75% YTM along with a 0.30 delta exposure to the equity. The solid balance sheet and worlds lowest USD/oz gold production would warrant a much tighter credit spread in our view, but Russian sanctions and non-benchmark issues caused a distorted perception. The same might be said for a Middle Eastern private health clinic provider, with bonds trading at 88%, 5% YTM and 0.35 delta exposure. The list goes on, and we believe the picture is clear.

The bottom line is that the macro environment seems to be stamping along at full steam, while equity valuations may have moved slightly ahead of themselves. Although the Fed seems overcommitted to keeping inflation in check, the recent equity market reaction seems slightly overdone. In Europe, the sell-off has been rather eye-opening, with markets off some 8%. All the fragmented market’s complexities, such as the Italian EU showdown and the UK’s Brexit negotiations along with trade tariff rhetoric, have put a cloud over the region. We believe the ECB’s on-going commitment to easy money will continue in the near term and that corporate profitability will continue to move forward. Whether this is a buying opportunity or not, we will leave to the strategists to determine. What is clear to us is that using this opportunity to add a solid allocation to CBs should provide opportunities to every asset allocator, be they equity, bond, or cross-asset.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment 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.
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