The best of both worlds: has the time come for convertible bonds to shine?

Faced with the prospect of interest rates going up at some point in the future, investors are starting to fear straight bond issuers clipping coupons. Meanwhile, with yields at their current lows there is no real opportunity for capital appreciation in long-dated fixed income.

“Convertibles are not priced the same way they were in early 2009 so they are not this no-brainer once in a lifetime opportunity. It [the market] is fairly priced, but within that there is lots of scope for alpha.”

Atul Shinh

Rates might currently be low, but elsewhere the backdrop includes a rising equity market, a scenario advocates believe fuels the case for investing in convertible bonds. These securities have a typically shorter duration than straight bonds and occupy a ‘hybrid’ position in-between equities and corporate bonds.

Before the financial crisis convertible bonds were mainly owned by hedge funds operating convertible arbitrage strategies which relied heavily on leverage. However, when the crisis hit in 2008 investors in these strategies wanted their money back and a firesale quickly ensued, prompting convertible bond prices to plummet.

Atul Shinh, a senior associate and member of the alternatives research team at Mercer, describes late 2008/early 2009 as a “once in a lifetime” situation for investors who picked up convertible bonds at rock-bottom prices. Since then, Shinh says Mercer has channelled between £1.5bn and £2bn into the asset class through its clients.

“Convertibles are not priced the same way as they were in early 2009 so they are not this no-brainer, once in a lifetime opportunity,” he says. “It is fairly priced as a general market, but within that there is lots of scope for alpha because there is dispersion in the attractiveness of the issues.”

A return to the norm

Essentially, the structure of a vanilla convertible is a corporate bond embedded with a long-maturity equity call option. When the price of the equity is low the convertible behaves like a corporate bond and when it is high it behaves more like an equity (see below).

Two main factors drive convertible bond issuance: interest rates and equity pricing. When interest rates are low convertibles issuance is low because companies use convertibles as a way to reduce borrowing costs. If, for example, a company usually borrows at 5% it can give away an option worth 2% and borrow for 3%.

But with low interest rates and high equity prices it is the latter which is has caused issuance to bounce back, because companies have taken advantage of the equity rally – if equity prices tick up companies can issue a convertible in order to borrow for less and then crystallise the stock value.

Convertibles issuance has increased in recent months, but rather than rising to unprecedented highs, this has been a return to what industry experts term ‘normal’ levels. According to Morgan Stanley Investment Management Global Convertible Bond Strategy manager Tom Wills, global issuance is on course to hit the $100bn mark this year, compared to around $70bn in 2011 and $60bn in 2012.

“It is not that it is a bullish issuance story, like high yield which is well over $1trn, but issuance in convertibles has recovered back to historic averages,” says Wills.

More stability, less volatility

Statistics show that historically, convertibles tend to perform in line with the best performing asset class. For example, prior to the dot-com crash when equities were rampaging, convertibles performed well, then in 2001-2003 equities sold off before rising again to be followed closely by an increase in corporate bond flows (see chart).

“In a period where equities are cheap, valuations are low but when there is a lot of uncertainty in the world buying an equity-like investment with more stability and less volatility is very attractive,” says Wills. He adds that generally speaking, over the last 20 years global convertibles indices have outperformed global equity benchmarks on a risk-adjusted basis but with around two thirds of the risk.

Other fixed income assets, such as high yield, rallied incredibly last year, but according to GAM convertible bond strategies co-manager Alex McKnight, the pure credit story has run its course. “Be wary of managers saying ‘we expect to clip a coupon this year’. As soon as you hear that, run. With yields at their current level there is not really any opportunity for capital appreciation.”

This, McKnight says, is the time for convertibles to shine because of their asymmetric return profile, which offers a good equity proxy. “If you buy a stock it can go to infinity or zero in a linear fashion. You buy a convertible and if the stock goes to infinity it is riding on the back of that and if it goes down it does not go to zero because it is a bond at the end of the day.”