Convertible bonds have long been under the radar relative to other asset classes. Despite the attractiveness of the asset class it is unlikely to be the first point of call for a typical investor.
Yet the relative lack of attention convertibles receive belies the qualities of a highly attractive asset class that benefits from a range of characteristics that can be of significant value to investors.
Over the long-term, convertible bonds have demonstrated their ability to deliver equity-like returns with less volatility than equities. Put more simply, investors can benefit from upside exposure to the equity underlying a convertible whilst retaining the intrinsic downside protection of a bond. Analysis of convertible bond returns over the long-term shows attractive risk-adjusted returns and absolute returns which have approximately matched, or even exceeded, those of global equity market indices, as well as corporate and government bonds.
Additionally, historical data shows that convertibles have demonstrated low correlation to government bonds and only moderate correlation to broader corporate credit markets, offering significant advantages from both strategic and tactical standpoints. From a strategic perspective, the relatively low correlation to other fixed income assets makes convertibles a highly attractive diversification tool which, coupled with their upside participation and downside protection capabilities, can play a valuable role in portfolio optimisation.
The prospect of interest rate increases in the US is focusing attention on the tactical attractions of convertibles. In addition to their low correlation with government bonds, convertibles have shorter duration than traditional corporate credit and may therefore be more resilient during periods of rising interest rates.
The growth of the convertible universe is offering an increasing number of opportunities to investors. The global capitalisation of the convertible market is around $400bn and is comprised of issuers across a diverse range of geographies, sectors and credit quality. The rate of convertible issuance has risen as companies increasingly identify the convertible bond market as an attractive source of capital for growth investment initiatives and for M&A activity. The technology and health care sectors in particular have been at the forefront of this trend.
The first quarter of this year witnessed solid year-on-year growth in global convertible issuance. We believe this trend will continue, as companies seek to secure a higher proportion of their funding from bond issuance and to reduce reliance on bank borrowing. Higher equity market valuations and the consensus expectation of rising US interest rates are also likely to have positive effects on new issuance, again providing an increased opportunity set for convertible investors.
Finally, investors can benefit from decreasing competition in the convertibles space. In recent years, bank proprietary trading desks have, by and large, closed and capital flows into convertible arbitrage hedge funds have been muted, creating valuation dispersion that may be exploited to secure attractive returns. This is particularly topical as M&A activity has picked up in recent months. Many convertible bonds have attractive structural features that allow significant upside participation in the event of takeovers.
The historical performance of convertible bonds suggests that a strategic allocation to the asset class can reasonably be expected to increase a portfolio’s expected return for a given level of risk, with the asset class’s low correlation to other fixed income assets making it an attractive tool for investors. In addition, the present macro environment, with the potential for increased interest rates, possibly higher equity market volatility and increased M&A activity, is likely to prove supportive for returns from the convertible bond market, proving it an asset class worthy of more attention from investors.
James Peattie is senior portfolio manager at CQS
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