Q&A: How will convertibles cope with volatility?

One of the traditional advantages of convertible bonds is that they win more in positive equity markets than they lose in falling markets. The rule of thumb was always two thirds upside participation, one third downside. Why did converts not deliver in the last twelve months?

We have seen two spectacular convertible bond years, for different reasons. In 2020 convertibles showed above average resilience in the Covid-19 crash, then stellar performance along side the rebound in equities. For the investment year 2021 we saw positive broad equity indices - the S&P in the US, Eurostoxx or the global MSCI World – but convertibles ended the year with a loss.

I have not seen such behaviour from this asset class in my career and you have to go back way into the last century to find parallels. The problem was the current composition of the convertible bonds universe. There is a strong tilt toward information technology, and disruptive consumer and communication names. This dynamic growth bias helped tremendously in the past. But markets have turned drastically against the coronavirus winners.

But this market rotation is not unique to convertible bonds. Why did equities hold up well before the Ukraine crisis?

Equity markets also suffered but it was a storm deep below the surface of the main benchmarks. The overall market breadth was small, and a few “big-hitters” drove positive stock market performance. You needed the likes of Apple, Microsoft and NVIDIA in order to generate performance. Without balanced convertible bonds outstanding, as a convertible bond investor you were cut off.

Similarly, in other sectors, in health and pharmaceuticals you needed Moderna and Pfizer as vaccine producers. The convertible bonds indices simply do not have these names. So the impact was earlier and more significant. A lot of the tech names in our universe have not only corrected over the last 12 months, they are in a deep red crash mode with losses of 50% from their highs.

Now markets are significantly down after the Russian invasion of Ukraine. How will convertibles cope?

On a line by line comparison, convertibles offer their traditional downside protection. However, we still see steep falls in some names irrespective of balance sheet strength or cash flow generation. Investors continue to put selling pressure on the asset class. Since the start of the year the Refinitiv Global Focus index, which is a good measure for balanced converts, is down 8% in US dollar terms. At least convertibles are outperforming stocks on the downside again, though downside shock absorbers could have been better.

How do you position in this situation? 

The most important thing, as ever, is to identify the strongest risk-return profiles. A lot of names which had been too high in risk have been driven back down in price and therefore also equity risk. These are now trading very close to their bond floor level, implying little downside, and some even show slight positive yields. Bonds with these characteristics look particularly attractive at the moment.

I see this as one of the striking differences with the rebound after the Covid-19 crash. Then the universe offered few good names and it was some interesting new issuance in the primary market which came to the rescue. Now there is a plethora of good convertible bonds in the secondary market, providing ample opportunities. But, the primary market also needs to change. We have seen too few new issues from energy, materials, or industrials that offer an inflation play. 

Do you see a silver lining for convertibles and what is the rationale for convertible bonds investors now?

Of course. There always is a reversion to the mean, for instance, where 2020 was simply too good, equally 2021 was way too bad for convertible bonds. With a lot of our underlying stocks having corrected drastically, we probably have already weathered the storm that is brewing in the equity market.

We have now reached rather low levels of equity exposure and hence overall downside risk in the convert market. And as I have said the structures are highly convex. As our underlying stocks are out of fashion, the valuations have suffered. On average, the asset class offers cheap exposure through its optionality, especially US converts are trading below fair value. We now need two things to happen. Firstly, a breather on the equity markets to evaluate companies more selectively, rather than indiscriminate, risk off selling. I believe that, perhaps similarly to the tech bubble bursting 20 years ago, there will be strong upside potential for those tech companies that survive.

And we need the primary market for convertibles to find the right underlying stocks. In the past, convertibles were always issued “where the music played”. It just needs to be a more upbeat tune in the future.