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Convertible bonds: natural asymmetry

4 April 2019

Although a fixed income asset, the structure of convertible bonds provides a natural asymmetry that has the potential to deliver long-term equity-like performance. GAM Investments’ Jonathan Stanford explains how convertibles work and why they can be an attractive asset to both fixed income and equity investors alike.

The ability for an investment to provide asymmetry – to reap the benefits on the upside, while providing protection on the downside – is fast becoming the holy grail of investment goals, albeit one that is hard to achieve with any consistency. However, we believe there is a much overlooked product which can offer these attributes as part of its inherent structure – convertible bonds.

It is important to stress that convertible bonds, or convertibles, are first and foremost bonds. They are typically issued by corporates in nominal amounts, carry a coupon, and have a defined maturity date at which they are redeemed. An investor buys the bond (ie money is loaned to the issuer), receives a stream of coupons and, at maturity, the initial investment is returned, much like any other bond (be it of corporate or government issuance). So why do convertibles produce long-term total returns that are more in line with global equity markets rather than global bond markets? The answer lies in the option to convert into common equity, if the issuer’s equity has performed well, or not to convert and wait for redemption if the underlying equity has performed poorly. As stated earlier, this translates into the ability to benefit from the upside of equity performance or to protect this initial investment on the downside; hence the natural asymmetry.

To put this into context here is an illustrative example. Typically new convertible bonds are issued with maturities varying between 3 to 5 years and conversion premiums ranging from 20% to 40% depending on various factors. Let us assume, for simplicity, that company Example Inc issues a USD 3 year convertible bond with a 3% coupon and a 20% conversion premium. Each USD 1,000 notional of this bond can convert into eight shares of Example Inc that are currently trading at USD 100. So the value of the convertible package of shares is USD 800 which equates to 20% less than the notional, hence represents a 20% conversion premium.

At maturity there are three possible outcomes: the stock of Example Inc is trading much higher and the convertible bond is worth more than USD 1,000; the stock is lower and the bond is not converted so the USD 1,000 notional is returned, plus the coupons received over the holding period; finally, Example Inc has gone bankrupt and the bond has defaulted. To expand on these scenarios, let us first assume the stock has declined 50% by maturity. An investor would have lost 50% of their money had they invested in the stock. On the other hand the convertible bond would have paid a coupon of 3% every year, as well as maintaining its notional value at maturity, representing a total profit of 9%. Now let us assume the stock doubled and is now trading at USD 200. Converting the bond into eight shares would then be worth USD 1,600, so rather than waiting for redemption at par, the bond could be converted and the shares sold for a profit of 60%, plus 9% of coupons would also have been received over the three years held pushing the total return of this investment to 69%. Not bad for a bond.

There are a few caveats of course. The yield on a convertible bond is often lower than for a regular bond. In our illustration, it would be likely that Example Inc would issue an ordinary bond (with no convertibility option) with a 5% coupon, which should deliver a 15% profit over 3 years. Buying the convertible bond would entail giving up a 2% yield per annum, albeit with the possibility of upside being generated by the equity price. The other caveat is the conversion premium can often be 20-40% above the current market – meaning the underlying stock needs to go up a reasonable amount before maturity for the investor to be “in-the-money”. There are also other positives though, such as in the unfortunate case of default. If the equity was purchased then the entirety of the investment would have been lost, whereas if a bond had been purchased there may be some residual value after bankruptcy as typically they are higher up the capital structure. Convertible bonds are most often issued as senior unsecured debt, much like any other corporate bond. This has been useful in many occasions of past debt restructuring.

With our example above, one can start to see the potential of this natural asymmetry of outcomes. On the downside the equity participation at maturity was minimal yet with the potential to earn a small profit generated by the coupons, while on the upside the equity participation was close to 70% of the equity gains. If we were to mark-to-market the bond well before maturity, the value of the convertible would likely reflect the performance of the equity to some extent. In our illustration, the stock halved so the tradable value of the convertible would probably be around 15% lower, sustained by its bond-like characteristics and the fact it could still be redeemed at USD 1,000 at maturity. This translates to the rough assumption that a convertible would participate in the range of 30% of the equity downside, but 70% of the equity upside. Our experience shows this illustration, although overly simplified, does represent the typical participation rate of balanced convertible bonds.

Historically, convertible bonds have tended to slightly underperform the equity market during strong rallies, but have demonstrated their ability to significantly outperform during severe equity drawdowns. Therefore over a market cycle, the asset class has tended to perform in line with equity markets, but with substantially lower volatility. In this respect, convertible bonds have demonstrated their ability to naturally hedge their exposure by accessing equity exposure in positive markets, while minimising equity exposure when markets move down.

Chart 1: Performance of European convertible bond market versus Europe Stoxx600 total return equity index since 1993

Source: Bloomberg; data from 31/12/1993 to 07/03/2019.

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

As shown in Chart 1, convertible bonds have delivered significant equity participation, while providing clear downside protection during periods of market stress. Only in 2008 did convertible bonds experience a sustained period of weakness, but the global credit crisis was a time when the very essence of the bond market was in dispute. And even then the downside for convertibles was considerably less than the equity market and the recovery time was much quicker as convertibles were posting new highs by the end of 2009. The bursting of the tech bubble in 2000 is another clear example of how convertible bonds managed to navigate a severe equity downturn with little damage; in this instance the credit market was not called into question as the stock market difficulties were largely related to equity valuations. Convertibles traded lower during this time, but were sustained by strong bond floors and par redemptions, while the market repositioned itself with new issuance being ready for the resultant pickup in equities.

These equity-like returns were generated with substantially lower volatility as illustrated in Chart 2. Generally speaking, volatility levels for convertibles have been half or even a third of the equity market and, since returns are comparable, the Sharpe ratios have been extremely favourable.

Chart 2: 360 day price volatility of convertible bond index versus Europe Stoxx600 index

Source: Bloomberg; data from 15/03/1995 to 07/03/2019.

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

As a medium-term equity alternative, an investment in convertible bonds is compelling, in our view. We have shown they can be a useful de-risking equity allocation tool, maintaining important upside potential as well as a low volatility alternative to equity. They can also provide attractive default protection than equities as they typically rank higher in the capital structure.

But it’s also important to consider how they relate to the fixed income market. When buying a convertible or corporate bond, the investor is taking the same capital risk, assuming both bonds have the same ranking. The only additional risk for convertibles is mark-to-market risk, as valuations can experience some degree of equity sensitivity. In our view, if one is comfortable with higher price volatility, but wants to maintain the same capital risk at maturity, then convertible bonds may offer the potential to outperform the general fixed income market. As illustrated above, convertible bonds typically have returns similar to those achievable in the equity market. If these levels of return can be generated while maintaining bond-like risks, we see no reason not to have a reasonable allocation to convertibles within any fixed income portfolio.

In Chart 1, the total return of the JPMorgan Aggregate Bond EUR index is also included as we believe this is an interesting proxy for the global bond market because it encompasses a variety of corporate and supra-national investment grade bonds worldwide. The EUR index also provides a realistic currency and interest rate comparison. As shown, the index performed well during a 20 year period of falling interest rates. However, it underperformed the equity market, and by consequence, the convertible bond market as well. Considering the general view that the market is now at the likely bottom of the interest rate cycle, it is hard to see this kind of interest rate tailwind continuing in the near-term and therefore we believe investors should be rather sceptical of the future returns for general developed market fixed income.

Convertible bonds generally sport much lower duration sensitivity compared to the average fixed income product. This reduced sensitivity to interest rates is not only due to their generally short maturities, but also to the positive effect of the equity optionality. On top of that, equity markets have often performed well during periods of rising interest rates and therefore the equity component could provide convertible bonds with further return potential.

Chart 3: European convertibles versus aggregate bonds (EUR)

Source: Bloomberg; data from 01/01/2014 to 07/03/2019.

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

Chart 3 illustrates the performance of the European convertible bond market versus the aggregate bond market, normalised to show the low point of the current interest rate cycle (8 July 2016). Since then, interest rates have not fallen further and have gradually trended higher. The chart shows the convertible bond asset class has outperformed the bond market, as we would expect, and it should continue to do in our view if rates continue to move higher.

We believe actively managed portfolios of convertibles are important, as benchmark indices in this asset class tend to hide all sorts of unwanted attributes. Often convertible indices include securities, such as mandatory convertibles, that are not actually bonds. Mandatory convertibles are essentially equity products, as the conversion is not at the discretion of the investor, but is mandatory at maturity. These in particular are often large in size and this can therefore be reflected in their index representation. Indices can also experience sector over-representation, if a particularly lengthy industry trend in issuing convertibles has transpired. The Dotcom era is a good example of this, as indices became heavily populated with technology issuers.

Convertible bonds are extremely flexible in how they are structured so that they meet the issuer’s needs as well as the end investor’s. Consequently, there can be many different profiles to choose from and can therefore offer flexibility in structuring a portfolio to help achieve a particular sensitivity profile and or match the yield potential an investor requires.

Since the bonds are generally medium-term in nature and designed for investors to lock in gains or receive their money back, it is particularly important to be vigilant regarding the credit characteristics of the issuer so that the probability of default is minimised. In the event of lower equity prices, the value of the underlying bond should not be in question as long as the credit worthiness is sound. Therefore robust credit analysis focusing on cash flow generation and balance sheet strength is important. This allows the investor to ride out any potential equity volatility, while waiting for the bond redemption.

We hope to have demonstrated in this paper that convertible bonds are simple in their nature and any complexity comes down to fine tuning on fair value calculations or arbitrage strategies. We have shown they have the ability to offer enhanced fixed income, with low duration risk for bond investors or present a lower risk equity alternative with comparable returns and higher capital preservation for equity investors. To any sensible investor, convertible bonds should be considered by both fixed income and equity investors.

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.