Outlooks 2017: Global convertible bonds
- Convertible bonds offer a potentially attractive combination of low duration and long equity participation
- Sudden market setbacks could be triggered by negative shifts in sentiment, swings in market liquidity or unanticipated shocks in fundamental economic data
- Investors are so used to low and negative interest rates that they will be in for a surprise when rates turn
- Convertible bonds with their in-built stabilisers could be an ideal asset class for these markets
Most investors look at the world through the rear view mirror. Those looking back at 2016 will see a surprising lack of volatility. Global equity markets calmly shrugged off both Brexit and the election of Donald Trump as the new US president. At the same time, rates have remained historically low and the negative rates for government bonds in Germany, Japan, and Switzerland were regularly in the headlines.
Looking ahead, this will change. Volatility can and will come back to equity markets, but it will come back at an unexpected point in time and from an unexpected direction. In risk management there is the idiom of “known unknowns” and “unknown unknowns”, a term going back to Nassim Taleb (and before that, the former US Secretary of Defense Donald Rumsfeld) and his work on so-called “black swan” events).
Elections, rate rises by central banks, or financial rescue packages for European states are known or at least expected events for 2017, even if we do not know the outcome or the market reaction yet. For some of these events markets are prepared. The market reaction to a potential Federal Reserve rate hike in December this year will (hopefully) be different to the one last year. For all other unknown unknowns, the market outlook suggests to us that the downside protection offered convertible bonds will be valuable in 2017.
Investors have short memories
It is important to remember that interest rates can go up as well as down. This does not have to be a general paradigm shift towards widespread rising rates, but we see that interest rates can move upwards suddenly and surprisingly strongly. When that happens, traditional government and corporate bonds face losses. The potential losses on the bond market are higher for bonds with higher maturities. This risk is expressed as duration risk.
Company treasurers have taken the opportunity to refinance and leverage up with the environment of low coupon payments. Overall, fixed income indices show a clear trend. Duration risk is significantly higher for conventional bonds compared to convertible bonds – and this risk position has drastically increased over recent years.
Why are convertibles so insensitive to rates?
First of all, a lot of convertibles are issued with a maturity of just five years. More importantly, they come with a conversion feature. Investors have the right to convert the bonds into stocks. This brings equity upside participation to the asset class. But the hidden gem in this conversion is the put on the bond. A true conversion not only includes receiving equity, it also includes getting rid of the bond.
As a long-running option right, we do not have to exercise this conversion right. As soon as the structure of the convertible moves closer to conversion price and builds up equity exposure, the interest rate part becomes increasingly unimportant.
To verify the practicalities of the structure, we need to go back in time to find longer periods of rising interest rates. There have been five periods with negative performance of government bonds - and hence rising rates - in the last few decades. These periods are different in length as well as in impact, but they have one characteristic in common: convertible bonds performed very well each time.
In our view, 2017 will be a year where protection becomes an important feature for our investors’ asset allocation. At the same time, it continues to make sense to build up smart equity exposure. If we are right, we will see supportive equity markets driven by a general shift from expansive monetary to expansive fiscal politics. In this environment well-structured convertible bond strategies have been shown to participate in a significant 75% to 80% of the equity upside.
Comparing convertible bonds to other asset classes, the advantages are compelling: low duration risk, strong stockmarket participation on the way up and hence an in-built inflation adjustment, effective protection against short-term set-backs, and to top it all, an under-researched and overlooked niche asset which comes at attractive valuations.
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