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Four reasons converts will rebound from ‘lacklustre’ 2016

RWC Partners’ Davide Basile believes underperforming asset class can return to favour in post-Trump bond markets.

Converts to turn the corner

Convertible bonds proved a firm favourite of fund selectors over the uncertainty of 2014 and 2015 but the asset class underperformed in 2016 as high yield found its footing.

However, RWC Partners’ Davide Basile, who runs the $1 billion RWC Global Convertibles fund, believes the asset class’s fortunes could be turning the corner. Here he gives the four key reasons why converts could once again emerge as sector standouts.

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Yield hunt still in the headlines

Basile said convertible bonds typically pay less income than other bonds because of the cost of the option to convert to equity, which has diminished appeal. However, the changing market has not removed the need to find yield.

‘Investment grade corporates have seen yields fall further than those in the convertibles space; while convertibles have seen yields compress globally from around 2 to 2.5% to 1 to 1.5%, the corresponding move for investment grade debt has taken yields from 5% to between 1-2.5%.

‘As such the carry or "opportunity cost" of the convertible bonds relative to straight corporate debt is substantially reduced,’ he added.

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Riding the rate rise

Basile pinpointed convertibles as a key ‘rate rise’ asset, which best performs when the market dynamics are changing.

'Convertibles derive c. 60% of their returns from their inherent sensitivity to equity markets, so in a pro-growth environment we anticipate that rising equity markets will propel the asset class higher, and given the duration of the asset class is relatively low the impact of rising interest rates will be negligible, especially when compared to that of traditional corporate bonds.’

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Vying with volatility

Convertibles serve an important dual role during times of stress, Basile said, with a pick-up in equity market volatility feeding through to valuations and also reduce any downside participation.

‘We notice that convertibles participate more with equities when volatility is higher and hence convertibles could provide investors with a more attractive way to get exposure to equity markets by allowing a strong participation to the upside while still retaining the usual capital preservation dynamics.’

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Picking up new paper

Basile said the ‘final part of the jigsaw’ is the level of convertible bonds being issued, which has increased against the backdrop of a planned rise in interest rates. Basile said the US exceeded the Q1 2016 level of new paper in January alone.

‘Over the longer term the asset class should benefit from its dynamic nature, with the bonds offering an attractive mix of downside protection and upside participation which enables returns to compound with low levels of volatility over time.’

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Davide Basile
Davide Basile
29/78 in Bonds - Convertibles Global (Performance over 3 years) Average Total Return: 10.22%
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