Markets

Outlook 2016: Convertible Bonds

Volatility is likely to persist into 2016, but convertible bonds could be well suited to such a backdrop.

10/12/2015

Dr. Martin Kuehle

Investment Director, Convertible Bonds

  • The market environment in 2016 is expected to remain volatile.
  • Sudden market setbacks could be triggered by negative shifts in sentiment, swings in market liquidity or unanticipated shocks in fundamental economic data.
  • Convertible bonds, with their in-built stabilisers, should be well suited as an asset class for volatile markets

Quantitative easing

After the financial crisis, stock markets entered a sustained bull market.

Convertible bond investors were rewarded with a prolonged period of strong returns.

The Federal Reserve’s (Fed) massive quantitative easing programme lifted markets and revived the US economy.

The Fed’s asset purchase scheme was then followed by the Bank of England (BoE), European Central Bank (ECB) and the Bank of Japan (BoJ).

The latter two are still supplying the global economy with vast quantities of liquidity.

Bull market

The Fed is now on the verge of lifting interest rates for the first time since it implemented the ‘zero rate’ policy in 2008, but the size of the financial experiment still makes the decision a first in financial history.

Still, quantitative easing has had and still does have direct and positive implications for equity and convertible markets.

We believe convertible bonds should continue to reduce equity risk for investors in 2016.

Equity valuations in Europe and Asia still look reasonable which, combined with a booming monetary base, continues to support the outlook for equities.

That said, we believe we are without doubt in the later stages of a long running bull market.

China headwind

Sudden and strong equity market setbacks are now a normal occurrence.

During the summer, Chinese stockmarkets entered a nose dive, with share prices shedding some 40% before levelling out.

In August and September, global stock exchanges lost more than 10% before recovering in October.

With low but positive economic growth we believe there are good reasons to stay invested in risk assets.

Each time, convertibles protected investors from about half of the equity market losses.

Convertible bonds, with their in-built stabilisers, proved to be ideally suited as an asset class for the year’s volatile markets.

We believe convertible bonds should continue to reduce equity risk for investors in 2016.

Converting opportunities

Convertible bonds offer this protection through a characteristic called ‘automated timing’. The automated timing function means that equity exposure decreases automatically when the underlying equity falls.

Importantly though, the equity exposure accelerates again in rising markets. Successful active exposure management and good security selection could add significantly to outperformance over the longer term.

In an age of unconventional monetary policy interest rates are likely to remain unnaturally low on a global scale.

Our most likely scenario for 2016 is for higher volatility to persist.

Sudden market setbacks could be triggered by either a negative shift in sentiment, a shock in fundamental data or indeed swings in market liquidity, especially at the lower end of the credit curve.

Risk assessment

Does that bode ill for risk assets in general?

No, we do not believe it does. We believe that ‘recovery rallies’ that often follow a break in a bull market mean that these periods of weakness could offer attractive entry points.

In an age of unconventional monetary policy interest rates are likely to remain unnaturally low on a global scale. This will hold true in spite of slow and very carefully orchestrated moves in the US interest rate.

Elsewhere, interest rates should stay low and may even fall further. With low but positive economic growth we believe that there are good reasons to stay invested in risk assets.

The question for us is not whether to hold equity exposure at all, but how much equity exposure investors should keep in their portfolios.

Over the last few years, I have been repeatedly asked if the time for convertibles was over, but we believe investors should stick to this asset class.

Over the longer term, convertible bonds should continue to provide investors with a compelling combination of smart equity exposure while retaining bond-like downside protection.