Insights

Convertible bonds – the best of both worlds

In this entry in our series of interviews on current topics, Senior Portfolio Manager Lukas Buxtorf talks about convertible bonds, an asset class that combines features of both bonds and equities and thus occupies a unique position in the investment landscape. 

Their dual nature sets convertible bonds apart in terms of risk and return characteristics, which once again has been convincingly demonstrated by the asset class’s impressive performance during the ongoing COVID-19 crisis.

What is a convertible bond?

A convertible bond is a type of bond that may, but does not have to, be converted into a specified number of shares of the issuing company. There are many different types of convertible bonds, but the common feature they all share is that their value is determined by both fixed-income and equity components. The fixed-income component is called the bond floor, which is the value that the bond would have if there were no convertibility attached to it. The value of the equity that the bond may be converted into is called the parity, and the difference between the convertible bond's price and the parity is referred to as the conversion premium. This structure enables convertible bonds to offer an asymmetric return in comparison with a standard equity profile, a phenomenon called convexity; the downside risk of convertible bonds is limited by their bond floor, while the equity component allows for unlimited upside from stock market rallies. This makes convertible bonds a hybrid asset class, since they combine the defensive qualities of bonds with the performance potential of equities.

Convertible bonds have been one of the top-performing asset classes in 2020. How were they able to overcome the challenging market environment?

Convertible bonds have indeed impressed so far this year. The broad universe, as represented by the Refinitiv Global Convertible Index, gained 17.14% over the first eight months of 2020. During the same period, while still positive, both the MSCI World Equity Index and US high-yield corporates recorded only a fraction of those gains in USD-hedged terms. While all convertible-bond segments came through the correction caused by the COVID-19 crisis relatively unscathed, some of them did particularly well, as can be seen in the index data in the table below.

Which segments performed well?

First, let me explain how we break down the segments. There are two very common ways to narrow down the convertible-bond universe. One way is to filter the universe by credit risk and only include investment-grade-rated instruments. This approach obviously suits investors seeking stable bond floors and the best-possible downside protection. Another way of narrowing down the universe is to only consider names with asymmetric (convex) risk profiles, as explained above. Refinitiv has a dedicated index for this segment, which is known as the “focus” segment. This index, or rather subindex, only adds convertible bonds with prices below 125% and conversion premiums of less than 75%. Hence, it does not include convertible bonds that are either too equity-like or too bond-like.

The broad universe, as represented by the Refinitiv Global Convertible Bond Index, gained 17.14% over the first eight months of 2020.

And how did those two groups perform over the first eight months of this year?

As you would expect, the investment-grade filter worked quite well in limiting losses during the drawdown period between February 19 and March 23, 2020. The Refinitiv Global Investment Grade Convertible Bond Index lost 13.9% during this time, much less than the unconstrained index, which dropped by 21.5%, and also performed marginally better than the “focus” subindex, which lost 15.6%.

However, in the subsequent recovery, the unconstrained index made up for that and even surpassed the “focus” segment by the end of August (17.14% versus 11.67%) while the investment-grade segment lagged by a wide margin in the recovery period and ended the first eight months at 4.02%, as shown by the index data in the above table.

That is quite a big difference. What happened?

There were two main factors working in favor of the “focus” segment. Most importantly, the booming technology sector accounts for around 30% of the “focus” segment but for only about 10% of the investment-grade segment. Secondly, the Refinitiv Global Focus Convertible Bond Index was rebalanced in April 2020. Many of its constituents had become debt-like as a result of the preceding correction. The rebalancing of the index replaced them with convertible bonds that had previously been too equity-like but became “balanced” again due to the correction. This rebalancing increased the delta – a measure of a convertible bond’s price sensitivity to changes in the underlying stock price – of the “focus” index. The timing in April was nearly perfect since the recovery was just about to start.

I think there are good reasons to believe that markets will remain volatile for the rest of 2020.

Interesting. Does the asset class still offer good value for the remainder of 2020?

Being a convertible bond fund manager, I am a natural advocate of the asset class, and I can give you two particularly strong arguments in its favor.

I think there are good reasons to believe that markets will remain volatile for the remainder of 2020. Apart from the threat of a second wave of the COVID-19 pandemic, geopolitical tensions between the US and China have intensified again, which may prove to be yet another impediment to a quick economic recovery. We also should not forget that 2020 is a presidential election year in the US and that the two candidates have quite opposing political agendas. All this considered, we are still sailing through rough seas and, in this kind of environment, you actually prefer to be long on convexity rather than short. 

Against this backdrop, it is particularly worth mentioning that convertible bonds are currently trading at rather cheap levels from a technical standpoint.

Against this backdrop, it is particularly noteworthy that convertible bonds are currently trading at rather cheap levels from a technical standpoint. In other words, volatilities implied by current convertible-bond prices compare quite well against the volatility exhibited by their underlying equities. This may be related to the record supply of new convertible bonds that the primary market offered in Q2 2020. While the total size of the asset class dipped below USD 300 bn at the start of this year, it is now approaching the USD 400 bn mark.

Lastly, I would like to mention that investors are currently spoilt for choice when it comes to convertible bonds. On the one hand, there is the investment-grade segment, which offers stable bond floors combined with a currently low delta of around 45% and good sector diversification. On the other hand, there is the “focus” segment, which offers a decent exposure of around 30% to the booming technology sector with a delta of around 60%. Without wishing to end the interview with a sales pitch, we do have very successful investment solutions in both of those segments.

 

Historical performance indications and financial market scenarios are not reliable indicators of future performance. It is not possible to invest in an index. The index returns shown do not represent the results of actual trading of investable assets/securities. Investors pursuing a strategy similar to an index may experience higher or lower returns and will bear the cost of fees and expenses that will reduce returns.

 

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