Convertibles: still mileage left after bumper run

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While the prospect of interest-rate rises and higher inflation could have many investors heading for the exits, these phenomena could brighten the outlook for convertible bonds as the asset class benefits from its position halfway between equity and straight bonds on the asset class continuum, adding another leg to its recent strong run

Skander Chabbi, CIO of the convertible bond team, explains.

Perspectives (P): Convertible bonds have come a long way – what have been the main factors?

Skander Chabbi (SC): Indeed, it has been quite an impressive run. The global asset class gained nearly 17%[1] in 2013, almost keeping pace with equities, but it was certainly well ahead of the main fixed-income asset classes. Convertibles’ performance was more than double that of global high-yield bonds and even further ahead of global investment-grade bonds, while leaving global government bonds – with a negative return in 2013 – in the dust. So far, global convertibles are almost half way on the road to our 8%-10% expected return for 2014. The asset class’s equity-like characteristics featured large in 2013 as the underlying equities benefited from growing signs of economic recovery, while so far this year – bond-like – the asset class has been able to benefit from concerns over the outlook for the Chinese economy and volatility related to geopolitical risk. This underscores the asset class’s convexity: its ability to capture most of the gains in rising equity markets and hold up well at times when equity markets are flat and investor uncertainty and market volatility cause appetite to swing towards the relative safety of fixed income.

P: Are convertibles still interesting in a market environment where the next moves in interest rates are likely to be up?

SC: Yes, we believe so. Historically, convertibles were able to benefit from their asymmetrical return profile at such times. In the March 1999-June 2000 and the December 2003-October 2007 rate-hike cycles, the asset class outperformed both aggregate bonds and equities[2], as illustrated by Exhibit 1, and we have no reason to assume that this will not happen again when official rates rise, even though we do not expect any significant policy tightening until the second half of next year, and then first of all in the US. It is worth noting that the convertible bonds we invest in have a duration of just over four years on average, which should limit their sensitivity to interest-rate risk. Given that we generally target convertible bonds whose performance has roughly 50% equity sensitivity and 50% bond sensitivity, we believe that we can be optimistic about risk-adjusted returns, even if the scenarios for 2014 are marked by uncertainty. You should remember that the likely interest-rate increases are made possible by the ongoing recovery in economies around the world, which is a factor that typically supports equity markets and by extension convertibles.

Exhibit 1: An asymmetric risk/reward profile, also when interest rates rise

Perspectives_interview

P: One driver in the run-up by convertibles has been persistent demand in a market marked by fewer and fewer new issues – do you expect supply to improve?

SC: It is true that amid inflows of investor money, tighter supply, particularly on the investment-grade side, has skewed prices. With nearly USD 100 billion in new issues, 2013 was ahead of 2011 and 2012, but volume was almost half that of 2007 which was a peak year marked by booming equity markets. So far, 2014 has seen USD 28 billion in primary-market activity. If this is maintained, issuance could match the 2013 total. That will not bring much relief in terms of liquidity in a market where one of two issues mature every month and are not replaced. Some 50% of issues are now being held by long-only funds, which provides a cushion for prices, as well as structural demand from institutional investors such as insurers who are buying convertibles to bolster their capital structure. For issuance to pick up, we would have to see definitive signs that interest-rate hikes are imminent, underscoring that now is the time for issuers to benefit from still cheap financing and rock-bottom issuing costs. A pick-up in capital spending as economic growth accelerates could also boost issuance. We believe a pipeline of quality issues is building up. Again, the US – already the world’s largest convertible bond market[3] – is most likely to be in the lead here in the near term.

P: What opportunities are left in the convertible bond market?

SC: On the face of it, you might say that Asia Pacific ex Japan is the region with the greatest promise since it is currently the only area that is undervalued[4]. But it is essential to be choosy here since this is also the region with the highest percentage of high-yield and non-rated issues and with the lowest sensitivity to equities compared with North & Latin America and Europe[5]. Globally, we still see selective opportunities – pockets of undervaluation – driven by regional and country-specific scenarios. Credit spreads are likely to tighten further and equity markets could strengthen, which should support corporate issuers in ‘peripheral’ countries and investment-grade names in the eurozone. Equity market strength could benefit convertibles in the US and Japan; in the US, it could be appropriate to switch out of information technology names, which have had a bumper run, and head for industrials, which have lagged. Asian convertibles could benefit from spread narrowing in the near term and, further out, from equity market strength. Away from this regional perspective, the prospect of (more) mergers and acquisitions, for instance among internet companies in China or in the tech and media segments in Europe and the US, should support the convertibles market. Growth in the US, the recovery in Europe, the real estate boom in the UK and Asian consumer demand are other themes we see as favourable for this asset class.

P: What do convertibles add to an investor’s portfolio?

SC: We believe this asset class can add better risk-adjusted returns to an equity portfolio given the asymmetrical nature of its return profile, while bringing down overall portfolio volatility.   For fixed-income investors, it can add diversification potential to the portfolios of those investors who are nervous about the outlook for bonds when rates rise, but who are also reluctant to take direct exposure to (the volatility of) equities. For bond investors in general, the inclusion of convertibles can soften the blow when interest rates rise since convertibles should hold up well, while straight bonds are likely to suffer. Relative to corporate bonds, we believe convertibles have more upside potential given the expectation of further equity market gains.   And as said, when times are uncertain, convertibles can be a good place to be for any investor since they can participate to a large extent in equity market gains and have mitigated downside during setbacks. Overall, we believe convertibles with their ability to ‘smooth the ride’ should be part of the core portfolio.

[1] Data from Bank of America; end-March 2014

[2]Reflected by the Barclays Global Aggregate index and the MSCI World index; data from Bloomberg, UBS, Barclays Capital, MSCI; January 2014

[3] Based on data from UBS, May 2014

[4] Based on the current richness/cheapness level of the Barclays Capital Convertible Bond index relative to the US, EMEA and Japan; source: Barclays Capital, April 2014

[5] Based on data from UBS, May 2014

Skander Chabbi

CIO of Convertible Bonds strategies

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