Convertible Bonds – in Search of Asymmetric Opportunities
Convertible bonds combine bond-like downside protection and equity-like upside participation; they are particularly suited to periods of high volatility and an uncertain market outlook.
2015 was an extraordinary year in many respects. It saw all major asset classes post negative returns. The pain was most acutely felt in the high yield segment, which dropped to levels not seen since 2009. Global investment grade and government bond indices were likewise in negative territory on the back of pronounced weakness in emerging markets. Convertible bonds (CBs) were the standout performer. CBs combine the most attractive features of conventional bonds (periodic interest payments and repayment of principal at maturity) and stocks (capital appreciation potential and a long-term inflation hedge) to offer what is often viewed as ‘the best of both worlds’.
Performance of convertible bonds
The Thomson Reuters Global Focus Hedged Convertible Bonds Index returned 3.7% in 2015, outperforming all other asset classes by a margin of more than 5%. Is this typical performance, and why did CBs deliver superior risk-adjusted returns?
Short-term results can be misleading and are not necessarily an accurate reflection of the long-term potential of different asset classes. It is therefore important to place CBs’ 2015 performance into a longer-term historical context: Over the last 18 years, CBs have returned 6.8% p.a. compared with 5.4% for equities, 5.5% for corporate bonds and 5.1% for government bonds. Furthermore, CBs have delivered this performance with lower volatility than equities and a Sharpe ratio nearly twice that of stocks. We believe that there are several factors contributing to this performance:
- Convexity: CBs combine the downside protection of conventional bonds and the upside participation of equities. This results in an asymmetric payoff profile, which by definition should deliver superior results over longer time periods, spanning both bull and bear markets. An additional advantage is the dynamic equity sensitivity adjustment embedded in CBs. In periods of rising stock prices, the equity sensitivity (delta) of CBs gradually increases, enabling higher participation in any subsequent moves. During bear markets, the declining delta ensures an ever-smaller downside participation as the protection from the bond floor kicks in.
- Special situations: These are events that generate positive bondholder returns regardless of the overall direction of credit and equity markets. They include, among others, corporate takeovers and extraordinary distributions. The majority of CBs offer takeover protection, which consists of an investor put at par and/or an additional number of shares per bond. On the distributions side, protection takes the form of a proportional adjustment of the strike price or a cash pass-through of the special dividend (features not present in call options and warrants).
- Marginal buyers: The crossover nature of CBs means they are of interest to investors in other asset classes. Low delta, positive yield-to-maturity CBs are a viable alternative for fixed income investors who may be attracted by the embedded call option or exposure to sectors that are traditionally not fixed income issuers (e.g., technology or biotechnology). In-the-money convertibles are often appealing to equity investors because of their higher ranking in the issuers’ capital structure as well as the differential between the CB interest and the underlying dividend yield. These non-dedicated convertible investors ensure that any mispricings in the CB market are of relatively short duration. As an added benefit, the presence of marginal buyers helps liquidity at individual security level, especially when compared with corporate bond deals of the same size.
When is the right time to buy convertible bonds?
Understanding how CBs work and appreciating the asymmetric return potential they bring to a portfolio is only one part of the investment decision process. Another, equally important aspect is the timing of such an investment. Dedicated CB investors tend to look at product flows and the overall richness/cheapness of the CB market when deciding whether to increase or decrease their exposure by using some of their cash reserves.