In addition, from a diversification perspective convertibles can provide investors access to an interesting dynamic of companies, often growth companies biased to small and mid-cap and typically within emerging markets (EM) which offers diversification, as well as an EM premium.
Insurance companies are also turning to convertible bonds ahead of Solvency II regulation coming into play. Under the regulation, insurers will be required to put up more risk capital if they hold equities, but because convertibles are legally structured as a bond they will not bear a high risk charge compared to equities.
Aviva Investors convertibles team fund manager Justin Craib-Cox explains: “They are more like a bond and that is interesting to an insurance company because they need to keep up with inflation, which equities do but they may not be able to afford the capital a huge allocation to equities will require.”
Size isn’t everything
Industry estimates value the convertibles market between $400bn and $600bn which, to put it into perspective, is less than the market capitalisation of Apple. This constrained capacity might lead investors to have concerns around liquidity. Indeed, super- sized funds such as some of the sovereign wealth funds or huge state pension systems, might be limited as to how much they could invest in these strategies because, for example, a $5bn investment would be about 1% of the entire market.
However, for most pension plans this is not an issue. Wills explains there is a total of about 1000 securities making up a total market of $500bn, meaning the average issue size is about $500m. “If you are trading one or two million bonds out of $500m then it is very easy to trade those securities,” says Wills.
Wills says MSIM is able to trade its fund on a daily basis, adding even though the high yield market is considerably bigger at around $1trn, the liquidity in the convertibles market is comparable for two reasons.
Firstly, because of the embedded equity option convertibles move more in price and that makes people want to trade them more. And secondly, hedge funds have always been players in the convertible market and they tend to trade more than the institutional market, which gives more liquidity than other credit markets.
But when it comes to liquidity, is the dominance of leveraged money in the convertibles space still a concern? Not according to Shinh, who says a reoccurrence of 2008 is unlikely because hedge funds now represent about 30% of the convertibles market compared to the 70% or so they did before the financial crisis. Being dominated by long-only investors means the market is now better scrutinised as they take a more bottom-up approach.
Read the small print
Elsewhere, concern has been raised about the fact that convertible bonds often do not have official ratings. According to Shinh, rather than being a disadvantage, “as long as we are comfortable the manager has the requisite skills to be able to analyse the credit quality of the issuers, we see that as a good opportunity for alpha and it does exist”.
GAM’s McKnight implores investors to read their prospectus to become aware of the legal obligations an issuer has to an investor. He says many investors have failed to note how they would fare in for example, takeover events, dividend distributions, seniority ranking compared to other bonds from the same issuer and so on. “These are basic credit concerns and as long as the investor is addressing these concerns you should be happy,” he adds.
Meanwhile, Shinh advises investors to use a specialist manager for convertibles because it is a complex asset class. “We have become cautious when an equity manager starts dipping into these investments,” he says. “A good indicator of that specialism is multi-asset managers who got into the asset class in 2009/10 but rather than do it themselves they more than often chose an external specialist to manage that for them. It’s not just the consultants; even the prudent managers themselves will recognise that.”
There has been a renewed issuance in convertibles in recent months buoyed by a rising equity market, even though the other driver – interest rates – have remained low. But this issuance has only seen levels bounce back to normal and with pricing also at normal levels, investors are unlikely to see a return of what now looks like the once in a lifetime opportunity seen in early 2009. However, for those seeking the upside of equity investment and the protective floor of a bond, convertibles could be the way to go.
Convertibles: asymmetric returns
If a convertible bond is issued for £100 an investor can convert it into five shares at £20 each. If the stock then goes up to £30 the investor still has a claim on five shares, but the bond will now trade at a market value price of £150 – and have a price above that because the option will have a future value as well. So the amount it can be converted into will have a floor price worth £100 as a bond, but the market value of that instrument is £150. If however the stock falls to £10 an equity investor will have lost half their money so the claim on the shares will now be £50, but as a convertible bond holder the investor still has an instrument with a £100 repayment promise.
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