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Convertible bonds are hybrid instruments combining bond and equity characteristics. As a result, they offer some equity upside, but with bond-like protection on the downside. If we are at the start of a cycle of rising interest rates, the option investors in these nominal assets (bonds) hold to convert to real assets (equities) could prove invaluable.
Skander Chabbi, head of the global convertible team, explains why this flexible form of capital is particularly suited to the current investment environment
Read the article or listen to the podcast with lead portfolio manager Skander Chabbi for the convertible bond strategy
With many financial markets focused on the prospect of rising interest rates and leading economies maybe on the brink of stagflation, it is timely to note that the duration of convertible bonds – their interest-rate sensitivity – is limited.
Unlike conventional bonds, convertibles have sources of return beyond interest rates. They include credit spreads, equity prices, and market volatility.
So in a rising rate environment, we expect equity market trends and credit to be the main drivers of performance. A gradual rise of market volatility is positive for convertible bonds. A convertible bond combines a bond and a call option (see exhibit 1). This option to buy the issuer’s stock typically increases in value when the volatility of the underlying stock rises.
Source: BNP Paribas Asset Management, September 2021
This combination provides investors with what we believe is an attractive total return profile with limited downside at times when the equity market does not perform. That is when the bond-like characteristics kick in – aspects such as the fixed coupon and the fact the bond is typically redeemed at par.
So, in the sharp and broad market downturn in February-March 2020, when the extent of the pandemic and the need for strict containment measures became apparent, the losses for convertibles amounted to only about a third of the downside seen in equity and bond markets.
More generally, when equities collapse, the performance of convertible bonds becomes more bond-like. So, as markets recovered from the slump, convertibles were quick to move in synch.
Convertible bonds – A cheap (re)financing tool
What we saw some 18 months ago was that many companies turned to convertible bonds to shore up their balance sheets. The terms for issuing equity would have been too onerous. The result was a virtuous circle – convertibles issuance improved credit ratings and narrowed credit spreads; this helped support the prices of the issuer’s equity; higher stock prices added to the attractiveness of the call options, which helped lift the convertible bonds.
The fact that stock prices were so depressed when this wave of refinancing began only added to the appeal of convertibles for both issuers and investors. Favourable interest rates were a further attraction of using convertible bonds as a cheap refinancing instrument. The embedded equity call option allows the issuer to lower the coupon so that it is cheaper to issue a convertible than a regular corporate bond.
In fact, we have even seen zero coupon convertibles being issued. Examples would include a US carmaker and a French utility, both with investment-grade credit ratings. High-yield issuers – with lower ratings – could be paying coupons of 1.25% or 1.50%. Examples of issuers would be a US airline, a US web and internet services company and an Indian telecommunications company.
To underscore the breadth of this segment further, with a market size of some USD 600 billion, recent issuers have included high-growth companies in the US tech and healthcare sector. We see this as a natural area for convertible bonds given the upside potential for their shares. In Europe, fast growers in the online delivery segment have issued convertibles, although I should point out that this area is now under pressure from rising costs and greater competition.
Overall, we believe there is a wide range of reasons for companies to issue convertibles.
A place for convertibles in many portfolios
Equally, we believe in the suitability of convertibles for many investors.
Taking the perspective of an equity portfolio manager who now faces high valuations in many markets and toppish index levels, convertible bonds can act as an alternative for a percentage of the allocation. To have some protection from equity market downside, but also keep a measure of equity exposure, they could switch into convertibles when they believe stocks have reached a high.
For fixed income managers who in the face of rising rates might want to limit their interest rate exposure, convertible bonds can be a way to reduce the duration of the portfolio given the lower interest rate sensitivity of convertibles relative to straight corporate bonds.
Looking at valuations, we believe convertible bonds are not expensive in the context of rising rates, that is, compared to the straight debt market. Furthermore, credit spreads relative to regular corporate bonds are still comparatively large, which should provide a cushion in a down market. In this respect, convertibles are adequately priced, in our view.
Overall, we expect a similar return from convertibles in 2022 to that of equities, which we estimate to be in the 5% plus range, with a much lower volatility in the convertible bond market.
We believe the wider appeal of this segment is underscored by the broad range of investors invested in it. Investors eyeing the equity-like characteristics include hedge funds and multi-strategy funds; those attracted by the bond-like aspects include credit investors such as asset managers, insurance companies, savings banks and pension funds. Even central banks have been buying convertibles.
To sum up, we see a place for convertible bonds in equity, multi-asset and even fixed income portfolios.