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Convertible bonds – a key component in optimizing asset allocation

Global convertible bonds demonstrated their merits in 2020, as the asset class outperformed both fixed income investments and global equity markets.

June 4, 2021

Oliver Gasser

Chief Executive Officer at Credit Suisse Investment Partners

Convertible bonds outperformed equities and bonds in 2020 

During the COVID-19 pandemic, convertible bonds proved their defensive characteristics compared to equity markets thanks to their fixed income component, or “bond floor.” The technical structure of convertible bonds meant that their sensitivity to equity markets (delta) automatically increased when financial markets recovered throughout the second and third quarters of the year. As a result, convertible bonds benefited disproportionately from the rebound.

While global convertible bonds are generally believed to have a relatively low equity sensitivity, a combination of unique factors led to their growth in value. These factors include such aspects as convexity, different sector weightings compared with equity and credit markets, and the dynamic adjustment of the universe – particularly at the start of the new issuance wave in spring last year. Whereas in the past small and medium-sized growth companies dominated the market, last year saw cyclicals become increasingly active. One prominent example was the travel industry, with jumbo emissions from the likes of Lufthansa and Southwest Airlines.

Is it already too late for convertibles?

The year 2020 was an exceptional one for convertible bonds. Does it mean that it is now too late to make new investments in convertibles? Due to various tactical and strategic reasons, we believe there is further upside potential for convertibles. At a time when bond yields linger around record lows – at zero or even going into negative territory – and equity markets reach record-high valuation levels, convertible bonds are more important than ever as an attractive alternative. The carry argument for fixed income investments has been exhausted.

At the same time, the disadvantage of convertibles – in the form of lower coupon payments (because investors are paying for the embedded option) compared to traditional bonds – is less significant than it has ever been. In November 2020, for instance, investors were able to acquire the above-mentioned Lufthansa convertible bond with a 2% coupon and five-year term at a premium of 42%. Shortly afterward, the same issuer offered a conventional bond with a 3% coupon and a five-and-a-half-year term. It is interesting to note that the convertible bond rose to 116% (as of February 10, 2021) on the recovery in the issuer’s share price, whereas the conventional bond (without a conversion right) fell by 2% due to the widening of credit risk premiums.1

Periods of elevated volatility in financial markets, like the one witnessed in January 2021, typically give convertible bonds a boost, enabling them to outperform equity markets. This is partly due to the long-term option of a convertible bond, which gains in value when volatility is rising, irrespective of the direction in which equity markets are trending. We believe that volatility – as measured by the difference between the actual and implied volatility – is attractively priced at the moment.

Furthermore, convertible bonds as an asset class show little sensitivity to interest rate changes due to their embedded conversion option and short maturities (around three to four years on average). They can therefore offer a certain degree of inflation hedge, which could prove a valuable feature given the recent rise in inflation expectations.

Convertible bonds

Thanks to their unique characteristics, convertible bonds present an attractive alternative to equities and conventional bonds, particularly in a challenging market environment.
 

Potential returns over the long term 

The year 2020, which featured extraordinary performance for convertible bonds, was not just a one-off phenomenon; in fact, in global terms, the niche has held up very well against the main asset classes of equities and bonds ever since the index time series for convertible bonds were first measured.

Historical asset class performance
Sources: Credit Suisse, Bloomberg; As of March 31, 2021

It is not possible to invest in an index. The index returns shown do not represent the results of actual trading of investable assets/securities. Investors pursuing a strategy similar to an index may experience higher or lower returns and will have to bear the cost of fees and expenses that will reduce returns.
Historical performance indications and financial market scenarios are not reliable indicators of current or future performance.

The main reasons for this attractive showing lie in the different structures and dynamics of the various asset classes, such as credit quality, sectors, regions, and growth versus cyclicals.

Fixed Income

Credit Suisse Asset Management is a leading active fixed-income and currency manager. With highly specialized investment teams, we offer innovative and customized fixed-income solutions.

Strategic optimization of asset allocation

When optimizing a strategic asset allocation, convertible bonds may prove particularly well suited as an addition to a well-rounded portfolio given their hedging characteristics and expected equity-type returns.2 The main objective of optimization is to minimize the risk of losses for a balanced portfolio (traditional balanced approach consisting of equities, bonds, real estate, and alternative investments). An optimized allocation indicates a convertible bond weighting of up to 20%, primarily of investment-grade quality. By contrast, global equities and traditional bonds are heavily underweighted.

The long-term performance of an optimized portfolio proves that maximum losses can be reduced and higher-than-average returns achieved. However, the added value of convertible bonds varies sharply depending on the market environment. A look at the various market scenarios shows that the expected return on convertible bonds in a highly positive market environment is superior to the return on bonds. Additionally, in a negative market environment, convertible bonds lose significantly less than equity investments. Overall, convertible bonds are less effective in neutral/positive market conditions given the predominant opportunity costs.

Conclusion

Convertible bonds offer long-term advantages compared with a traditional equity/bond portfolio because the equity option component dominates in the current, much-discussed inflationary environment; in a period of deflation, on the other hand, bond protection comes into play. Convertible bonds therefore offer the best of both worlds: in a variety of financial market scenarios, they contribute to the stability and profitability of the portfolio – even though in a normal expansionary phase this is paid for in the form of a reduced return.

The question, therefore, should not be whether to start allocating to convertible bonds. Rather, it is about how extensive that allocation should be based on expectations of future market scenarios.

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1 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance.
2 See SIM Research Institute, in cooperation with Credit Suisse Investment Partners (Switzerland) Ltd: “Resilient portfolio construction with convertible bonds, commodities, and gold.” December 5, 2020.

Source: Credit Suisse, otherwise specified.
Unless noted otherwise, all illustrations in this document were produced by Credit Suisse Group AG and/or its affiliates with the greatest of care and to the best of its knowledge and belief.

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