Outlook 2018: Global convertible bonds

A lot of people take Vitamin C supplements to boost their health during winter months and protect themselves against flu and colds. For those of us who come through the winter season without a cold the question remains whether we were just lucky or whether indeed the intake of Vitamin C did help to protect us.

In financial markets, the answer is much more visible, and for 2017, in hindsight, very clear cut: investors did not need protection.

Back at the end of 2016, we observed that the preceding 12 months had seen a “surprising lack of volatility¹” and predicted that volatility would return, but “at an unexpected point in time and from an unexpected direction”. Our overall view is not significantly changed 12 months on.

Politics or monetary policy to upset “Goldilocks” market?

Going into 2017, fears of rising populism in Europe might have been one potential destabilising factor. But these concerns seem to have lifted after a series of national elections, with reduced political risk now giving a tailwind to markets.

Even more severe negative political news, such as North Korea firing rockets across Japan, did not deter markets. The fiery war of words between North Korea and the US only prompted a short-lived blip in positive market sentiment.

It is hard to see such imperviousness to these kinds of external risks continuing indefinitely, while there is scope for similar occurrences in 2018 to precipitate a more meaningful market downdraft.

While political news may drive short term performance, shifts in global monetary politics and interest rates should have more lasting effects. The US is in a rate hike cycle. The European Central Bank (ECB) is tapering its bond purchase programme to €30 billion a month until September 2018. The only big spender left amongst central banks is the Bank of Japan (BoJ).

Clearly, we have passed the point of maximum quantitative easing (effectively money printing) – and markets are still applauding. This too may be the prompt for markets to reappraise, either as reality sinks in or if US rates go up faster than markets expect.

Macroeconomic fundamentals very much supported the strong rally this year: throughout the world, economic growth is solid and has surprised most economists on the upside. The International Monetary Fund (IMF) has just revised its growth outlook in the US up to 2.2%, Europe is growing with similar speed, with peripheral countries contributing, and Asia remains the growth region of the world.

At the same time, inflation remains benign – or more to the point unexpectedly low, with unemployment rates the lowest since 2008. Wages are still not rising meaningfully. Until they do, this will remain a tailwind to corporate profits and preclude the need for aggressive monetary tightening. The positive, albeit moderate, global growth outlook continues to look set fair.

Altogether then, 2017 has seen a “Goldilocks” scenario for risk investments, such as stocks. Investor appetite for risk was barely tested and volatility remained remarkably subdued. We feel it can only be a matter of time before this changes.

How long can low volatility last?

The volatility of the main convertible bond index, the Thomson Reuters Global Focus, registered just above 2% through 2017 (based on monthly figures as at end-November). At the same time, the index returned almost 9% in US dollar terms. Investors received a 4% return for one unit of volatility. This is astonishingly high in a historic context and almost certainly not sustainable.

Markets seem to be complacent. In the US, where the Nasdaq was the best performing market in 2017, we can also find telecommunications firms and network providers with substantial losses for the year.

Investors recently have seemingly become more optimistic, have started to take the low volatility level as normal, and have a stronger belief that well-telegraphed central bank decisions will not come with any surprises. The more optimistic the general market becomes, the more investors should be prepared to take chips off the table and increase allocations to lower risk investments.

One of the biggest advantages of convertible bonds as an asset class, however, is the low importance of timing the investment between bonds and equities. We have seen first hand in the past year how a badly-timed asset allocation decision may still have a positive outcome, in absolute terms.

As such we do not have to be overly concerned with exactly when the market turning point will come, but consideration needs to be given to other asset class.

Toward the end of 2017 we saw some pull-back in stocks, leading to some re-evaluation of convertibles. Our models indicate a cheapening of convertibles in all regions of the world to a level of 2.5% above fair value.

Convertible bonds, as any asset class nowadays, remain a little expensive, but this first cheapening of market prices versus what we view as fair value may be a market signal. Any more of a setback than this could provide buying opportunities within the asset class.

Valuation of convertibles appears extended

Source: Schroders* as at 15/11/2017 based on constituents of the Thomson Reuters Global Focus Convertible Bond Index (*reflects our bespoke valuation model where 0 is fair value).

Defensive qualities

As we remain conservative in our 2018 outlook, essentially waiting and preparing for the meaningful repricing of risk assets, it seems reasonable to once more emphasise the defensive qualities of convertible bonds. Compared to equities and conventional bonds respectively, these include lower sensitivity to equity set-backs and rising interest rates. We would not be surprised to see these characteristics demonstrated in the coming year.

In our view, one of the smartest parts in any investor’s asset allocation is convexity. In the context of convertible bonds this refers to the fact that prices will tend to fall at a slower rate than the underlying equity.

The potential to gain more on the upside than lose on the downside, compared to other assets, may sound trivial, but it is a firm foundation for long term success. A well-run convertible bond strategy could be expected to achieve lower positive returns than equities, but with some downside mitigation.

There is a famous saying: you can look rather stupid just before or just after a bubble burst – but the latter will cost you more money. Convertibles take a lot of pressure away from timing the bond-equity allocation decision, so you could end up looking a bit smarter.

^{1. A statistical measure of the fluctuations of a security’s price. It can also be used to describe fluctuations in a particular market. High volatility is an indication of higher risk.↩}