Outlook 2023, Global convertible bonds: the return of convexity?
Convertibles have traditionally offered effective downside protection in volatile markets and are presenting a resilient and smart way of building up equity exposure.
- Convertibles showed disappointing downside behaviour in the first half of 2022
- Primary markets are on a record low
- Downside level should protect better from potential ongoing volatility in 2023
The past year has seen convertible bonds deviate from their usual convexity (a measure of the duration of a bond's sensitivity to interest rates). In the first half of 2022, global stock markets were dominated by tighter financial conditions as central banks finally realised inflation was non-transitory.
Russia’s invasion of Ukraine intensified the increase in energy and raw material prices, and stock markets turned deeply negative. Higher interest rates significantly weakened the underlying equity universe of the asset class, which caused convertible bonds to suffer above average.
Source: Bloomberg as of 21 November 2022
The second half of 2022 presented two short and sharp bear market rallies. Markets had been oversold and market participants had increased net short position to hedge exposure. The mere hope for a Fed pivot, or even hope of a Fed pause towards the end of the year, was enough to move markets strongly up. Convertible bonds benefitted from this equity tailwind in these short upside markets.
Looking back, the universe of convertible bonds was heavily tilted to growth companies. Information technology was the main sector, but communication and most of the consumer names leaned towards disruptive and dynamic platform businesses.
This universe reacted, and continues to react, more to moves in the Nasdaq than the overall MSCI. Comparing converts to Nasdaq-listed growth stocks, the downside protection is much more prominent.
Activity picking up again
The convertible bond primary market was very depressed in the first half of 2022 but came back to life in the second half. As a result, we expect the past year to show a record low of around $40 billion only. The overall universe of convertible bonds has now fallen close to $500 billion, according to Refinitiv as of November 2022.
In our opportunity set, we are mainly recycling convertibles from 2020 and 2021 that moved up in strong equity years and have now re-entered our balanced universe. This gives us good flexibility to find interesting companies and invest in convertibles which could show good upside participation if and when markets turn.
It is a positive sign that companies are not desperate for refinancing. The next wave of companies issuing convertibles is likely to be driven by illiquidity on other bond and credit markets and will only offer a very selective opportunity.
Still, we are looking forward to companies from cyclical sectors such as industrials, materials, or energy coming to the market. There has not yet been much convertible refinancing for the vast changes needed to move the global industry to a net-zero carbon target, although convertibles are a fantastic financing source for corporates. US firms should find attractive conditions even in a higher interest rate environment.
Source: Schroders, Refinitiv, as of 31 October 2022.
Positioning for a bear market rally
One of the most significant statements in this year’s market updates was: “The US Federal Reserve has clearly triggered an economic climate change.” Since then, we have seen the sharpest interest hikes by the Fed in history. The quadruple 75 basis points (bps) moves in as many meetings have been unprecedented, combined with a $95 billion quantitative tightening. This gives rise to the proposition that the Fed is already too restrictive.
It looks like the November hike has terminated the 75bps series. The Fed will not pivot yet but reduce further hikes all the way to a pause in early 2023.
Overall, the sharp interest rate rises have triggered a $30 trillion equity loss on the US stock markets. That is a bigger loss than in the 2008 global financial crisis. The financial conditions in the US have seen the biggest change downwards since 2008 and the global credit impulse is weaker than in the 2008 doldrums. On the US house market, both the Case Shiller home price index and the Zillow rent index have come down already. And convertible bonds have suffered peak to trough losses that are very reminiscent of 2008.
With all these parallels one crucial part is missing, illiquidity. Credit spreads have not exploded, either in the investment grade, or on the junk bond market.
Still, this looks like a car crash in slow motion. The persistently rising inflation took the central bank drivers by surprise, and they slammed the breaks on too hard. Moreover, the Fed is steering by looking into the rear-view mirror. Both the strong labour market and the housing and owner equivalent rent, as part of the inflation calculations, are delayed data. The outcome clearly is an economic crash into a recession.
Despite all this market negativity it is good to stay positioned for a potential bear market rally. Raw material prices have come down significantly, energy prices – even in Europe – have dropped after the gas storages have been filled, freight rates have shot down and computer chips inventories have gone up. All that will drive down inflation – and that is before base effects come into play. The Fed needs to give inflation calculation a chance to catch up.
Although this is positive for the short-term, there are no signs of a new bull market cycle. Traditionally, equity markets find a bottom after two-thirds of a recession is over. The central banks need the first third to accept that the economy is indeed in a recession. Globally, we are in that stage even though third-quarter growth rates in the US look positive.
On the other hand, US saving rates have already dropped to a mere 3.1%. In a coming recession, central banks need to find the right supportive measures. In the US market that could be a pause in interest rate hikes and a termination of quantitative tightening. In the last third of the recession, stock markets could then price in the bright future for the economy. However, we are not there yet. In fact, we are not anywhere close to that point.
Why convertible bonds in 2023?
Finally, it is important to point out the limited power the European Central Bank (ECB) actually has to mirror the Fed. With every new print of inflation data (the recent inflation data from Germany remained above 10% in October) the ECB must decide to either really fight inflation or risk breaking the euro. The weakest link in this chain is, of course, Italy. If the new Italian government was to mention a tax reduction mini-budget (like the UK did), let alone actually implementing it, it would be game over. Apart from the ECB, there is not a single buyer of Italian government bonds at an interest rate level that Italy can afford.
Overall, and given that a significant part of our convertible universe is US and growth driven, we remain constructive on markets and see three strong arguments for an investment in convertible bonds.
Firstly, we need to see a stable and sustainable return to traditional convexity features with good upside participation and efficient downside protection. This overall litmus test for convertibles has improved periodically since the first half of 2022. We hope for a similar upside reaction to a potential bear market rally. In terms of equity exposure, convertibles should offer a much higher protection as the inbuilt optionality remains low.
Secondly, the sell-off in convertibles started much earlier than broad markets and the underlying equities suffered strongly. The overall effects resemble those of the bursting of the tech bubble in 2001. From a fundamental view, most of the companies are non-cash burning, but delivering revenue. On top of that, our universe is biased towards US names. Compared to the dire situation in Europe, this looks like the preferable market. In 2023, change can further be triggered by new issuance of good credit companies entering the convertibles market, a return of value versus growth on the stock markets, and a more supportive central bank policy.
Finally, convertibles remain cheap and are trading around 2% below their fair value. That is in line with a sell-off of risk assets in general, but again the situation looks overdone, and the asset class is oversold.
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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.