Are convertible bonds an all-weather asset?
Does equity protection mean bond risk?
For investors in convertible bonds, the protection offered during weaker equity markets is often the most enticing feature. But how good is the asset class at protecting against fixed income risk?
Traditionally, the two key risk measures for fixed income assets are duration and credit risk. Duration reflects the sensitivity of a bond to changes in interest rates. Higher interest rates are generally bad for bonds, and duration is generally higher in government bonds and investment grade corporate bonds. Credit risk reflects the stability of a bond issuer and, by extension, its ability to repay the bond capital and make coupon payments. Credit risk is generally more relevant for high yield corporate bonds.
Unusually, the current market backdrop means that both risks are currently a concern for bond investors.
The step-change in inflation expectations and the rise in the US headline interest rate at the end of last year caught many bond investors wrong-footed. Even so, the Federal Reserve (Fed) has been vocal about further hikes. When it does raise rates again, we expect interest rates in Europe to climb too.
Ordinarily interest rates rise when economic growth is solid. While this is broadly true just now, there are a number of reasons credit risk could also rise in 2017, especially in Europe.
Greece will have to refinance €8.2 billion in government debt in July; this time without the help of the International Monetary Fund (IMF). The Italian banking system is also far from sound. The €20 billion earmarked to shore up the Italian financial system may not be enough if liquidity is severely compromised by capital flight.
Moreover, the European Union and the euro remain under political pressures from impending elections in France, Netherlands, Italy and Germany.
Convertibles versus duration
So what does this mean for convertibles?
Looking first at global government bonds as “duration assets”, through seven periods of rising interest rates since the new millennium, investment grade convertible bonds have protected investors from falls six out of seven times. In some periods, convertibles made significant advances.
The fact that convertible bonds include a right to sell the attached bond reduces interest rate duration. Hence, convertibles have historically been effective inflation-protection assets. On balance, convertible bonds with an investment grade rating gained 7% through the last seven periods of interest rate increases.
Convertible bond returns during interest rate rises
Source: Merrill Lynch and Bloomberg, February 2017
Convertibles versus credit risk
Given the lengthy era of quantitative easing and zero-interest rates in major bond markets since the financial crisis, flows into high yield bonds have more than trebled since the end of 2009. While understandable, some investors may have overlooked the degree of credit risk that this builds up. If convertibles are not overly exposed to duration though, it also begs the question of how they respond to bouts of significant credit spread widening.
The evidence is encouraging. Since the 2008 financial crisis, high yield corporate bond investors have faced several setbacks. In all periods, defensive, investment grade convertibles outperformed on the way down.
Convertible bond returns during credit risk spikes
Source: Bloomberg, February 2017
The current market backdrop certainly has the potential to put significant pressure on both duration assets and those carrying primarily credit risk. However, a well-defined conservative convertible bond strategy aims to deliver value exactly in this type of scenario.
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