At GAM Investments’ Weekly Investment Meeting held on 15 May 2019 the speakers were Jonathan Stanford, who explained the benefits of convertible bonds, and Lars Jaeger, who discussed the latest investment research in the ARP space.
One of the appealing attributes of convertible bonds (CBs) is their natural return asymmetry – potentially reaping benefits on the upside while providing protection on the downside. We view CBs as an alternative to fixed income, particularly when fixed income markets are encountering difficult periods, but with the potential for equity-like returns combined with fixed income levels of volatility. This volatility can be managed via delta and a focus on credit quality.
It is also important to stress CBs 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.
Historically, CBs 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, we believe they have demonstrated their ability to naturally hedge their exposure by delivering equity exposure in positive markets through the embedded option to convert, while proving less vulnerable to equity downside in reflection of their fixed income attributes.
Over the last 25 years CBs have marginally underperformed equity markets, both in Europe and the US, but have delivered performance well ahead of fixed income markets. During periods of low interest rates, such as that which began in July 2016, a switch from traditional fixed income into CBs would have continued to provide decent levels of return. Yet it is important to note, CBs can exhibit large fluctuations in their valuations based on the supply / demand dynamics. In movements caused by flows they tend to overshoot on both the upside and the downside.
At present we have the unusual situation, last witnessed in early 2009, where many CBs are yielding more than their ‘straight’ bond counterparts. As such the option to convert is not only free but CB holders are effectively being paid to own it. The fact straight bonds are eligible for the European Central Bank ongoing bond buying programme also has a bearing in driving yields down and enhancing the relative attractiveness of CBs. At this point, the ‘bond floor’ (or minimum value calculated from coupons and return of principal) of CBs is also high by historical standards (around 95% of NAV), meaning these securities offer a positive asymmetric return profile.
We favour Europe over the US and emerging markets, a stance which differs from the much more US-centric benchmark.
Merger and acquisition activity can offer arbitrage opportunities, but we have seen limited numbers of these so far this year. In terms of new issuance, there have been 10 new issues in Europe this year worth EUR 7 billion and 49 deals in the US with a total value of USD 22 billion. Meanwhile in Asia there were 12 deals worth a combined USD 17 billion. We are hopeful of further issuance, particularly in Europe.
Alternative Risk Premia
As we have noted previously, 2018 proved a difficult year for most asset classes and investment strategies and, unfortunately, alternative risk premia (ARP) was no exception. As with the broader market, the performance of ARP strategies in general this year has recovered. However, there continues to be a high level of dispersion across these returns which, in our view, demonstrates that ARP is not a commoditised asset class or offering and, in such a heterogeneous arena, the choice of manager should be considered important. We favour a diversified offering, which tends to avoid overcrowded spaces, and seeks to avoid biases towards specific components of the spectrum such as ‘value’ and ‘momentum’. Clearly, those strategies with a particular bias will invariably perform very strongly when their favoured component of the spectrum is leading the broader universe – but this also makes them more vulnerable to drawdowns – while the volatility of their returns will invariably prove significantly higher.
We believe that choices made throughout the key areas of the ARP investment process, such as strategy implementation and portfolio construction, are crucial in framing longer-term return profiles. As such the ARP space is not heterogeneous simply because of varying risk exposures across the ARP manager universe; the spread of returns and the ability of certain managers to consistently outperform the average ARP manager highlights that there are stable and less stable ways to implement the ARP investment paradigm in our view.
In terms of investment research, we are currently focusing on the development of new value indicators as it becomes increasingly evident to us that some of those in common use have finite lifespans in terms of their ability to add value. We have also noted that the returns we are able to generate from commodities trend exposure have, in the last three years, tended to be lower than our expectations (although commodities ‘carry’ has remained a positive driver of returns in that time). As such, we are attempting to determine whether a regime shift has taken place, requiring a totally new trend model, or if we simply need to fine tune our existing one. Similarly, we have observed opportunities to add value through dispersion trends in the volatilities of different stocks, but the significant trading costs incurred in pursuing such a strategy need to be taken into consideration. Consequently, we are debating and examining different ways to trade the volatility curve of individual stocks to negate the impact of higher bid / ask spreads, as well as trading commissions.
In our view the dispersion of ARP returns witnessed in both 2018 and calendar year to date underlines the need for a specialised and experience-based approach. Experience has proved more vital than many have assumed since ARP, while appearing to be simple and intuitive in concept, is notoriously tricky to implement, with many details. Our view firmly remains that a robust investment process, with experienced researchers and thoughtful portfolio construction, can shape future outcomes for the better.
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Source: GAM unless otherwise stated.
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. 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 do not represent any recommendations by the portfolio managers. Reference to a security is not a recommendation to buy or sell that security.