Navigating tech sector volatility with the help of convertible bonds - lessons from the past
With the recent summer stock market sell-off sending ripples of unease through the tech sector, it might just be a new season for convertible bonds.
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After this summer’s volatility in the technology sector, attention may turn again to the often-underestimated instrument, the convertible bond. With around US$400 billion invested globally, convertibles offer an intriguing proposition, bridging the gap between the growth potential of equities and the defensive nature of fixed-income securities.
Below we dissect the performance dynamics of convertibles in the context of historical market events from the tumultuous period surrounding the dot.com bubble and subsequent market recovery. Based on data from the globally representative MSCI ACWI Index contrasted against the FTSE Global Focus Convertible Index, a common proxy for convertible performance, we discuss the resilient character of convertibles and offer an insight into how such securities can serve both as a buffer in turbulent times and a module of growth during market upsurges.
The dot.com bubble and narrow market breadth
Before July’s sudden wake-up call for stocks, equity markets were characterised by a narrow market breadth, driven by a select few highly capitalised tech companies, while most companies already trended downwards and traded below their technical averages. Although the performance of a few stocks versus many may seem inconsequential for broad market investors, the differentiation gains significance when considering the risks associated with participating in a crowded trade. Both the narrow market breadth and the focus on tech remind investors – at least the older ones of us – of the 2000 tech bubble.
Lessons from the dot.com bubble
The market narrative surrounding today's tech companies has some similarities to that of the dot.com era. Back in 2000, investors were enticed by impressive revenue growth and assumed it would continue indefinitely, while some companies thrived, questions remain about the sustainability of certain technological advantages.
The aftermath of the dot.com bubble is often considered a lost decade for global stock investors, but convertibles provided protection. Today's popular tech stocks, however, differ from their predecessors with robust revenue structures and limited reliance on external financing.
A significant number of dot.com companies lacked viable and sustainable business models. They were focused on rapid expansion and market share capture without a clear path to profitability. As investors began to question the long-term viability of these companies, the bubble started to deflate.
This shift in sentiment led to a significant sell-off of technology stocks.
So, reasons for the dot.com bubble burst included the absence of sustainable business models, high valuations based on speculative profit predictions, investor reassessment, and the US Federal Reserve's tightened monetary policy.
In the aftermath of the dot.com crash, convertibles rebounded faster than global equities, including the Nasdaq. Nasdaq investors only saw positive returns post the Global Financial Crisis. The recovery time for the global stock market, without adjusting for inflation, was slow.
Chart 1: Convertibles, global equity and tech stocks
Convertible bonds: defensive characteristics and performance
Convertibles are hybrid securities that combine debt and equity characteristics. They can resemble low-volatility, low-beta stocks in their performance, occupying a unique position that bridges different asset classes. In declining markets, convertibles provide downside protection, limiting share price declines through the bond floor. This lower downside performance risk makes convertibles appealing to investors who are cautious about stock market risks.
The role of convertibles in portfolio allocations
Allocating to convertibles as a separate asset class provides draw-down reduction compared to stocks, potential sector and regional diversification and stability, thereby enhancing the properties of the overall portfolio.
In terms of the Dot.com crash, convertibles showed a remarkable downside protection.
Chart 2: Loss Protection (Dec. 1999 – Mar. 2003)
The loss protection provided by convertibles enables investors to recover from market declines more effectively. Forgetting the impact of losses, such as needing to regain a larger percentage to break even, is a common oversight. During the Dot.com bubble, where Nasdaq investors lost over 75%, their required recovery exceeded 400%.
Convertibles also demonstrated upside participation, generating a 60% return from the market bottom to the point of global stock recovery. Overall, balanced convertibles proved to be a smarter equity investment during this period.
Chart 3: Convertibles and global equities
Parallels with today's market
While history does not repeat itself, it often rhymes. Assuming overall financial conditions remain favorable, central banks continue providing ample liquidity, and credit events can be avoided or postponed, at least a significant sector rotation out of the overcrowded tech trade may be on the horizon.
Companies struggling to attract liquidity on traditional corporate markets might resort to issuing convertibles, offering cheap equity coupled with high coupons. Convertibles have always remained open in times of illiquidity, and early signs suggest the high yield refinancing market is already experiencing challenges.
In summary
With the anticipated refinancing wave and tighter credit conditions, convertibles are well-positioned to protect against stock market losses. The defensive nature of a significant portion of the convertible universe reaffirms the attractiveness of this asset class and its ability to provide inherent protection during equity market downturns.
This feature already came back into focus in the late July / early August stock market set-back. Convertibles once more protected from sudden equity market losses. We remain confident that in any potential future rotation trade out of tech stocks, convertibles could follow a similar protective pattern.
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