IN FOCUS6-8 min read

How convertible bonds can help protect portfolios from the effects of the 3D reset

The 3Ds – demographics, deglobalisation and decarbonisation - can all contribute to inflation. We examine the protective role that convertible bonds can play should a potential recession cause a fall in equity markets.

19/10/2023
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Authors

Dr. Martin Kuehle
Investment Director, Convertible Bonds
Cedric Spiegel
Assistant Fund Manager, Convertible Bonds

Major shifts in demographics, deglobalisation and decarbonisation (the 3Ds) are shaping markets. And the two central themes at the heart of this new era are high inflation and central bank action to curb that.

The 3Ds all impact inflation. Demographic changes, such as an ageing population and declining birth rates, can lead to a shortage of skilled workers. This can result in higher salaries and costs for companies, which are then passed on to consumers through higher prices. The global labour force participation rate is expected to decline from 61.2% in 2020 to 60.9% in 2030 due to demographic changes. As populations age, there may be fewer workers available, leading to labour shortages and higher salaries. According to the McKinsey Global Institute, by 2030, the US alone could face a shortage of up to 18 million college-educated workers.

Deglobalisation can also have an impact on inflation. As countries become more inward-focused and less reliant on international trade, there may be fewer opportunities for companies to source goods and materials at lower prices. The Covid-19 pandemic was a wake-up call.

Decarbonisation efforts can impact inflation in multiple ways. Companies investing in expensive technologies to reduce their carbon footprint may experience higher production costs, which can be passed onto consumers as higher prices, contributing to inflation. Additionally, the transition to cleaner energy sources can lead to higher energy prices, further driving inflation.

The production and distribution of energy from cleaner sources may entail higher costs, resulting in increased energy prices. This, in turn, puts upward pressure on inflation. The International Energy Agency's report highlights that achieving net zero emissions by 2050 will require substantial investments in clean energy technologies, potentially leading to short-term increases in energy prices.

In Europe, Germany has pushed the energy transition fast, in a bid to cut its dependency on Russian gas and shut its final nuclear power stations in one go. As a result, German industry now faces high energy costs which has led to a recession in Europe’s biggest economy.

Furthermore, there is also the potential for "green inflation". This is inflation that is driven by the costs associated with decarbonisation efforts. This can include higher costs for clean energy technologies, as well as higher costs for raw materials that are needed to produce clean energy technologies.

Overall, the impacts of the 3Ds will be inflationary.

Will central bank’s bring interest rates back to the levels we’ve seen over the past decade?  

The simple answer to this is no – or at least not in a planned and forecasted soft landing scenario. We won’t be seeing a low inflation, low interest rate environment again soon because after years of quantitative easing and flooding the markets with liquidity, central banks were not prepared for the rise in inflation and reacted too late. Inflation had already started to rise fast already before the supply shocks post-Covid re-opening, or surging energy costs caused by Russia’s invasion of Ukraine. However, most central banks saw a significant transitory effect only. The idea that the labour markets were heating up and forming a wage price spiral was not spotted early enough. Central Banks finally started to act in 2022. In March that year the US Federal Reserve (Fed) raised rates for the first time by a mere 25bps and then followed through with hikes all the way up to the current 5.5% In Europe, the European Central Bank (ECB) followed in July that year and moved rates to 4%.

Chart 1: Comparing the speed of interest rate hikes (1988-2023)

Convertibles 3D

This rate hike cycle turned out to be the steepest and fastest since the early 1980s.

Together with rising rates, central banks cut liquidity supply and reduced their balance sheets. In the last six months, the Fed alone has taken $600 billion worth of liquidity out of markets via quantitative tightening.

But perhaps this time will be different?

That is also one of the costliest statements in investing.

When we look back at central bank hiking cycles, there is a very clear lesson to be learnt from history. Usually, central banks are late and overstep the mark. The US has the longest history of data shown in the graph below.

Chart 2: History of US Federal funds effective rate since 1955

Convertibles 3D

With the exception of the 1985 hike, all Fed rate hikes led the US economy into a recession. The chances are very high that it will not be any different this time.

We may all have underestimated the spending power of the US consumer in the first half of 2023. Now, delinquency rates, or the amount of debt that is past its due date, at US credit and store card providers are up and consumers have even dipped into their pension savings as the 401k hardship loan spike shows The latest Job Openings and Labor Turnover Survey (JOLTS) reported fewer open positions than previously. The ADP research saw fewer than 180,000 new jobs being created in August, staying below expectations. It looks like Fed chair Jerome Powell’s words are finally starting to ring true, when he said last year that fighting inflation “will bring some pain to households and businesses”.

With the pain finally starting to be felt in the economy – though not yet on global stock markets – it looks like the Fed may have reached the end of its rate cycle for the time being. However, without a serious deterioration in economic growth we cannot see lower rates on the short-term horizon.

Interest rates are high and will remain high. And higher rates are slowly eating into the cost structure for consumers, for companies, and for governments.

Convertibles can offer protection in recessions and equity market set-backs

Looking back at the last three Fed rate cycles, it took an average of just six month to choke the economy enough to start a recession. The early 2000 recession coincided with the bursting of the tech bubble. The 2007 financial crisis popped the real estate bubble. The 2020 recession was probably caused more by the Covid-19 pandemic and the subsequent harsh lockdown measures than higher rates. In addition, monetary and fiscal policy did a very fast U-turn and provided support for the economy. Hence, the 2020 recession was steep but also short-lived.

All recent recessions have led to a weakening of risk in the equity market  and caused significant losses for equity investors.

Chart 3: Convertibles – Reaction to rising rates – and following recessions

Convertibles 3D

Convertibles, however, have persisted through the market ups and downs due to their in-built advantage: automated risk reduction in a market set-back.

During previous recessions, the protection rate of convertibles against equities has varied from 67% to 47%, strengthening the long-term investment case that convertibles can protect investors from about half of equity losses.

And we believe that convertibles will again deliver downside protection when a potential recession causes equity markets to fall.

Downside protection is only half of convexity. What needs to change is the market structure so that convertibles can add value in and shortly after a recession

Usually, the weakening of investor sentiment and equity market set-backs come with illiquidity. In the future, it is likely that we will see high demand for refinancing from companies which will not be able to attract liquidity on traditional corporate markets, and they will offer cheap equity on top of high coupons by issuing convertibles. After all, convertibles have always been the market that stayed open in days of illiquidity.

On the bond side, the global high yield bond market has increased by a factor of five since the financial crisis, while the convertibles market remained almost on the same capitalisation. There is a lot of refinancing coming up – and it is coming up at significantly higher interest rate levels and with much tighter credit conditions.

The most dangerous day for any fixed income investment is the day of maturity. Does the company have the liquidity or the refinancing to repay the debt? The risk of default jumps significantly when refinancing conditions are tight, when interest rate costs are considerably higher than before, when bank lending standards are tighter, when default rates are on the rise, and when less liquidity is around. And yes, that is the situation now – or at least, in the very near future.

We were there in 2009 when optionality was a free lunch, and we think we may see similarly attractive pricing levels in the future.

But first changes in the market structure are already obvious. We see a strong primary market for convertibles this year – in strong contrast to the lacklustre activity in 2022. Here it is important to see that the current new issuers tapping into the convertible market are not desperate for refinancing, but opportunistic market participants trying to save on their coupon payments. We are happy to provide the financing as the premium has come down. This is decisive for the valuation of the overall structure. With a convertible, we are happy to pay a premium on top of the parity (i.e., the stock value of the convert) at launch because we receive a long running option. At high points we have seen premia of 35% to even 40% on the primary markets. These have come down sharply to a general level of 25% to 30%. That means that stocks only have to make up around 5% per year for us to get to an option structure that is then in the money.

Chart 4: Annual convertible issuance over 25 years

Convertibles 3D

Also, with higher interest rates, there is more coupon income. Of course, income should never be the primary investment rationale for convertibles. But the market is now paying us to wait in an attractive risk return structure for the underlying stocks to move. Whereas at the low point, our standard index the Refinitiv Global Focus came with a current yield of just 0.3%, you can now receiving an income of more than 1.3% in USD.

Although good times may await further down the line, in the meantime convertibles have to deliver protection against stock market losses. For the time being we remain defensive, with a negative view on the medium-term market picture and see more volatility on the horizon.

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Authors

Dr. Martin Kuehle
Investment Director, Convertible Bonds
Cedric Spiegel
Assistant Fund Manager, Convertible Bonds

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