Market Views: Fixed Income
Outlook 2020: Global convertible bonds
- Higher market volatility is bringing convertible bonds back into fashion with selectively attractive valuations.
- The protective qualities of convertibles have been tried and tested in recent years and look well placed given the array of risks and uncertainties in the world.
- Return potential remains strong with interesting opportunities in growth companies in the investment universe following solid 2019 issuance.
As we close out a fruitful year for financial markets, it’s fair to say that 2020 will not start with the same recovery potential as we saw at the beginning of 2019.
The market’s view of monetary and fiscal policy has also shifted. For 2020, it seems highly likely that central banks around the world will be supportive with lower interest rates, significant quantitative easing, and perhaps even other non-conventional measures from the central banks’ tool boxes. Moreover, governments seem prepared to start spending significantly more and the age of austerity really does seem over. Eventually, even Germany may lift its foot off the “Schuldenbremse” (debt brake).
On the other hand, geopolitical risk is abundant as ever, albeit ebbing and flowing. Like a lighthouse with its rotating spotlight, only parts of the rocky cliffs are in the news beam at any one time. Italian financials and the difficult budget situation light up, followed by China-US tariff wars, before the light moves on to Brexit in the UK. Then suddenly sluggish data from Germany, with a special focus on its car industry, or the economic slowdown in China, seem to dominate news. Just every now and then, our lighthouse beam does not light up any rocks or dangers at all, as was the case in 2019 when investors bought strongly in to the idea of the central bank put keeping the bull market going.
Our forecast for 2020 is that markets will be pulled between these two factors; bullish risk-on phases with sudden market jumps will be followed by sudden gloom. Hence, volatility will potentially be higher than this year.
What advantages could convertibles provide for your asset allocation?
We are reasonably sure that downside protection will work. There are three parts to this argument:
- The overall equity exposure in convertible bonds is at the lower end of the balanced spectrum and also low when we compare this to the last five years. Convertibles should generally come with lower downside risk. Moreover, we are tactically defensive and most of our strategies come with lower exposure compared to their benchmarks.
- In a market which has already seen strong equity gains where convertibles are up significantly, we usually notice a strong demand for the asset class – and hence higher valuations. Despite strong returns from the asset class in 2019, convertibles are fairly priced, in our view. European convertible bonds look expensive, but we continue to find some value in regions such as Japan and Asia. When securities are already trading on fair valuations, this adds another cushion against a potential re-valuation should markets decrease.
- Convertible bonds are not immune to default risk, but the investable universe is dominated by strong companies with an implied investment grade rating. Around two thirds of the convertible market have this high credit quality – either through a direct official rating, or a market implied fair value rating. In our broader, unrestricted strategies, where we can add sub-investment grade convertibles, we are positioned defensively with strong underweights in the worst rating buckets.
The bottom line is that we feel that we can weather a sudden market storm.
Convertibles well placed in a balanced economic and market outlook
Finally, let’s turn a bit more confident for 2020, and look at the positive aspects including the likelihood that a recession is averted, renewed search for yield and the restored risk-on appetite of investors. Overall, while parts of the equity market have come a long way, sentiment remains far from irrational exuberance. Equity holdings seem still a bit light, and opportunities are emerging in convertibles which are trading well below their 2019 highs. The overall market looks under-invested.
Convertibles have delivered for investors over the last 12 months, outperforming equities on a risk adjusted basis (taking into account the amount of volatility) once more. The Sharpe ratios in the chart below show the units of return for every percent of risk in the two asset classes.
Over the long run, a case can be made for convertibles offering attractive returns with lower volatility than equities. We believe that 2020 could just be another year to prove this.
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