Outlook 2021: Convertible bonds

  • Convertibles are undervalued and should continue to provide some downside protection against market declines
  • Convertibles market should benefit from increased representation of IT companies and ESG trends
  • Markets broadly look vulnerable to setbacks with asset class correlations likely to rise

Despite one of the most serious global pandemics ever seen, global equity markets delivered strong returns in 2020. The MSCI was up over 15% for the 12 months to end-November 2020.

Focusing on equity market returns only, one may be forgiven for thinking 2020 was a year of strong economic growth and robust corporate profits. However, other metrics paint a different picture altogether.

In response to the shock, the Federal Reserve (Fed) reduced interest rates from 1.75% to 0.25%. Debt levels and central bank balance sheets ballooned - the combined balance sheet of the Fed, ECB, Bank of Japan, and People's Bank Of China rose by $9 trillion in 2020. The US 2020 budget deficit hit $3.3 trillion or 15% of GDP. The price of gold jumped by 22%, while the oil price (WTI Crude) dropped 23%.

Covid-19 had a drastic and sharp impact on the way we live, interact, consume and trade and we go into 2021, with the world much altered compared to a year ago.

Convertibles offering downside protection

Convertible bonds have demonstrated their qualities in 2020. One of the unique characteristics of convertible bonds is “convexity”. Their part-bond, part-equity nature, means that in a best case scenario they largely keep up with rising equity markets, but the bond component limits losses when stocks and markets are falling. These characteristics were evident in 2020, with the asset class seeing limited losses amid the Covid crisis in February and March.

Convertible bonds was in fact one of the few markets to stay open for trading and more importantly remained a source of refinancing for companies in the weeks of illiquidity in March. There was also substantial issuance on the primary market for convertibles. Between April and October 2020 more than $100 billion of new converts hit the market, according to Refinitiv. A considerable amount of this was from the IT sector, this presenting ample opportunity to participate in the forceful tech-driven market rally.

Overall, balanced convertibles, as measured by the Refinitiv Global Focus index, protected investors from more than 60% of the equity market losses in February and March, but achieved 65% of the equity market gains in the rally till the end of November. We also saw the potential for sustainability or ESG factors in convertible bonds as oil and commodity-related convertibles were impacted by the low oil price.

Convertibles have outperformed stock markets. Usually, such strong performance would drive up the valuations of convertibles, in the past to as much as 3% to 6% above fair values, but this did not happen.

The significant primary market liquidity kept valuations low, in our estimation resulting in a surprising misvaluation, due to high supply. So there is scope for positive performance in the event of either strong or weak equity markets.

Should markets turn south, the downside protection is strengthened and the misvaluations act as a further cushion. Should market continue to rally, there usually is a string reverse to the mean and the current misevaluation will bring another performance boost.

Markets displaying irrational exuberance?

Now at the end of 2020, equity markets have priced in each and every piece of good news: advances in vaccine, significant new fiscal stimulus, and further excessive quantitative easing. Rational markets would at least be asking questions: how many passengers are taking flights these days despite vaccines with a 90% and higher success rate, what part of the forecasted $2.2 trillion US fiscal stimulus will really pass a Republican-dominated Senate, and how long could some EU member states potentially delay the €1.8 trillion fiscal support package.

Clearly, there is a degree of irrational exuberance. On the other hand, this makes it easy to forecast at least one variable for next year: volatility will remain high as we will see periodic set-backs in the equity markets.

Another relatively easy forecast for the year ahead is the liquidity-driven behaviour of assets in a crisis. We believe that similar to the spring 2020 Covid-19 crash, correlations will jump towards one. That means that all assets will move in the same direction, prices either rising or falling in synch, throughout the spectrum of stocks, bonds, converts, gold, and other risk assets. Simply put, there will be no place to hide. As diversification between asset classes becomes less effective, the built-in downside protection from convertible bonds could prove highly useful.

Convertible bond valuations attractive

With the typical wave like dynamic, the convertible issuance market has once more found the ideal spot in 2020. Convertibles point investors to “where the music plays”. However, it is important to constantly rebalance risk, sell into rising markets and lock in gains as eventually, the music will stop playing. Currently, the market structure of convertibles is biased toward US Information Technology companies with an average implied sub-investment grade credit rating.

We are constructive about the longer-term market dynamic. There is a huge wave of liquidity  and a very clear message from central banks that rates will remain low, quantitative easing will remain high and that they are backing markets.

The move by the Fed to average inflation targeting should lay to rest fears of another rate cycle. With years of undershooting inflation targets, central banks will remain dovish even if and when inflation rears its head. This can only be good for non-nominal risk assets – as long as investors judged their risk budgets correctly and can remain invested in times of a market set-back.

For those of us who do not have the stomach to weather the big market storms, there is a clear message: convertibles have protected in the past, and given valuations there is every chance they will protect again in 2021.

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.