In the second part of our closer look at the challenges facing convertible bonds, leading investors set out how equity-like returns fit into the equation and why the new issuance of convertibles is on the wane. (For part one please click here)
There is no doubt that the outlook for convertible bonds will largely depend on the equity market, says, Kris Deblander, ranked 15th over five years and manager of the Edmond de Rothschild Global Convertibles fund.
As he remains positive on equity markets, he thinks the asset class will perform well because the average equity sensitivity of convertible bonds is relatively high.
The risk that threatened the asset class during the second quarter was expensive valuations in some parts of the universe (Europe, investment grade) but convertible bonds became cheaper in the early summer and they are now back at fair value.
‘We are therefore, quite confident convertible bonds are now better positioned to show an asymmetric profile going forward,’ he says.
‘With the good performance of equity markets year to date, we should also see high levels of new issues coming to the market. As these are placed with a discount, this should help convertible bonds to perform well.’
Deblander also believes that convertible bonds should be considered as a standard asset class for asset allocation purposes.
‘While convertible bonds share common features with equities over the long run, they only have half of the volatility, which provides them a unique risk/return profile,’ he says. ‘As such they improve the efficiency of any portfolio already invested in bonds and equities.’
The key, he believes, is the creditworthiness of the issuer. ‘We will avoid companies with significant refinancing needs in the short term,’ he says.
According to Dr. Martin Kühle, investment director for convertible bonds at Schroders, there are a couple of key trends within this space. The first is that it’s getting increasingly difficult to find cheap credit.
‘Look at the high yield market – it’s certainly a little bit overbought and hence you shouldn’t act too much down the credit curve,’ he says. ‘The fact is that you really need to know what you’re doing in this area.’
The other trend is a consistent demand for convertibles at a time when there is a very low level of supply. ‘This is due to a lot of fixed income investors looking at convertibles because they can’t find yield anywhere else,’ he says. ‘It’s this whole search for yield trend.’
Picking up new paper
The lack of new issues can be explained by a couple of factors, he suggests.
‘Firstly, no chief finance officer is ever happy to sell the equity at a low price,’ he says.
‘The second is cannibalism. Straight bonds were a great method of refinancing and there was so much capital being pumped into this sector there was no need to issue convertible bonds.’
Now that interest rates have turned in the US and because it’s getting a bit more difficult to refinance at those levels, the market has once again seen convertible bonds come back to life over the past few months.
As a result, the levels of new issuances are also on the rise. ‘This is the first year for three years where we are thinking of a growing convertible bond market rather than just replacements of maturities, calls and puts,’ he says.
However, being successful in this market requires a focused approach on convertibles and the support of a powerful resource capability, he says. ‘We are a true convertible bond fund, so no derivatives, no options, no synthetics, nothing really other than a core convertible business,’ he says.
As far as the coming months are concerned, Bryn Jones, a fixed income fund manager at Rathbones, points out that equity markets are trading at much higher levels, which may result in a lot of convertibles trading more in line with the equity share prices.
However, he says that it all depends on your perspective on investment markets as to whether or not they look good value. For example, an investor focused mainly on fixed income is likely to have a different take from someone trading mainly in equities.
‘The irony is that for fixed income investors, convertibles right now look an expensive game because you’re taking equity-like risk,’ he says. ‘However, equity investors can find lower delta convertible bonds that might be quite attractive as it inhibits their downside.’
Jones believes that from the standpoint of diversification, it makes sense to have some sort of exposure to convertible bonds because they can help deliver a smoother performance over the longer term.
‘If you have a small exposure to convertibles it helps manage your volatility and can provide better risk-adjusted returns,’ he says. ‘Also, if we do have interest rates remaining on very low levels for a long time then convertibles are going to perform very well because they’ll continue to benefit from equity markets going up.’