Contact

Menu

Article

Why convertible bonds are useful during market volatility

These are tough times for investment professionals. They have to manage risks, enhance returns, and keep investors patient as they navigate through uncertain times. To make matters worse, inflation is back after being away for 40 years.

December 20, 2022

Key takeaways

  1. Over the long term, convertible bonds are known for providing equity-like returns with a lower volatility profile, which can limit downside risk during a market sell-off.
  2. Convertible bonds are useful for managing risk, enhancing returns, and helping investors navigate through uncertain times.
  3. They give investors the ability to participate in an equity market recovery and also offer downside protection during times of market volatility.
  4. Convertible bonds are a very dynamic asset class and can swiftly adapt to different market environments. When underlying equities decline, they take on the protective characteristics of a bond. When underlying equities move higher, they start behaving like equities.

Right now, every tool and innovative solution is needed. One of those could be convertible bonds. These extraordinary securities are a type of bond like no other. What makes them different is that they can be converted into the shares of the issuing company, which gives them unlimited upside potential.

The attraction behind convertible bonds

Over the long term, convertible bonds are known for providing equity-like returns with a lower volatility profile, which can limit downside risk during a market sell-off. From a fixed-income perspective, convertibles offer a significant yield enhancement and bear low correlation to interest rates, plus they provide added diversification to a fixed-income portfolio.

However, what makes convertible bonds interesting in this market environment is the way they behave. In a post-pandemic world, where there is rising inflation and interest rates coupled with recession fears and a highly uncertain economic outlook, predicting the direction of the market is difficult. This has been especially true during the first part of 2022, when both equity and bond markets sold off sharply in unison.

Subsequently, there is strong demand for asymmetric investment strategies that help limit further losses, while offering some upside participation. This is exactly what convertible bonds might be able to offer.

Recession: how to turn the enemy into your best friend 

The recession bells are ringing and fixed income investors are rebalancing.
 

Why convertible bonds can offer an asymmetric payoff

Let’s break this down visually. Take a look at Figure 1. One of the benefits of holding convertible bonds is that they offer upside participation when the stock market rises. However, this is less of a driver in today’s market, as equity markets have experienced a significant correction this year.

What is more interesting is the bond floor that convertible bonds offer. It provides investors with something that helps them protect against downside risk (See the green dotted line in Figure 1). As a reminder of what the bond floor is, it is a lower price barrier for the convertible bond. It is equivalent to the present value of the future cash flows if the conversion option is not exercised.

If the convertible bond is out of the money, it behaves like a conventional corporate bond, where changes in interest rates and credit quality have a much greater influence on pricing. However, a convertible bond holder has the right, but not the obligation, to convert the bond into shares. Therefore, in an extended negative market environment, the right to convert will not be exercised and the bond repays at the par value.

Figure 1: Convertible bonds offer an asymmetric payoff

The image illustrates data presented in the material.
Delta - A ratio comparing the change in the price of an asset, usually a marketable security, to the corresponding change in the price of its derivative. Source: Credit Suisse. For illustrative performance only.

As a matter of fact, as per October 31, 2022, one out of four convertible bonds traded at a price of below 80%, and one out of five offered a yield of more than 10%. What is quite encouraging is that convertible bond issuers tend to have “clean” and unlevered balance sheets. Currently, almost half of the convertible bond issuers that trade below 80% have no other debt on their balance sheets apart from their convertible securities, and most of them were issued at 0% or at very low coupons back in the years 2020 and 2021 when rates were still very low. Hence, for many issuers, interest expenses are relatively low and refinancing will not be an issue anytime soon.

Another important point to note is that historically, convertible bonds also tend to outperform equities during periods of high equity market volatility. Conversely, convertibles tend to underperform during periods of subdued volatility. As Figure 2 shows, market volatility has gradually risen since the start of this year.

In this type of environment, the main driver of return is the downside protection provided by the bond component, as higher volatility tends to be associated with falling equity prices. Interestingly, the negative impact on the option value is partially mitigated by the higher volatility, which, ceteris paribus, increases the value of the option that is inherent to the convertible bond (see Figure 2).

Figure 2: Convertible bonds outperform equities when volatility trends higher

The image illustrates data presented in the material.
Historical performance indications and financial market scenarios are not reliable indicators of future performance. Source: Bloomberg

How have convertible bonds fared in 2022?

From a cross-asset class perspective, convertible bonds, together with equities and traditional bonds, did fall during the first half of 2022. There are a number of reasons why this happened. The pricing function of the bond floor that convertibles have was put under pressure. The problem is that both interest rate risk and credit risk rose in tandem during the first half of 2022.

The theoretical value of the bond floor, which is dependent on both interest rates and credit risk, moved lower. This reduced the downside protection that investors usually receive from convertible bonds. Convertible bonds also tend to be issued by small- and mid-cap high-growth companies. This segment was hit particularly hard during the equity correction experienced in the first half of 2022.

Although convertible bonds struggled during the first half of 2022 on a relative basis, we have seen significant stabilization during the second half of this year. The asset class has broadly remained in positive territory and correlation to global equities and traditional bonds has moderated. We believe this relative strength may persist for longer due to the current risk profile of the asset class.

Due to the recent correction, the universe offers a unique profile of deeply discounted bonds with a positive yield, plus the long-term right to convert the bonds if market conditions become more favorable. If the market remains under pressure, the current mix of credit profiles and a convex balanced segment of more than 50% will provide a more stable risk-return path than recently experienced.

On the other side, price multiples of the underlying equities fell in 2022, credit spreads widened, and convertible bond valuations remain undemanding. This is a combination that arguably risk parameters like duration, equity sensitivity, and the bond floor provided by convertible bonds are in combination historically cheap and offers a good entry point into the asset class.

For those investors who continue to believe that the market outlook remains uncertain, convertible bonds offer an attractive option as well. They give them the ability to still participate in those equity market gains if markets recover further. Meanwhile, convertible bonds also offer a degree of capital protection and diversification in the global portfolio context. 

Get in touch

Contact us for information about investment opportunities and to learn how we can help you achieve your investment goals.

Please note the following risks

  • Potential loss: There is no capital protection for investors. They may receive back less than they invested.
  • Market risk: Market conditions can trigger fluctuations in total returns.
  • Exposure to emerging markets: Investments in emerging markets entail greater risks than investments in industrialized countries. These risks include a certain degree of political instability, relatively unpredictable financial markets still in the developmental stage, and dependence on the economic situation.
  • Liquidity risk: Some investments may entail liquidity risk.
  • Foreign currency risk: A given investment’s total value can be adversely affected by exchange rate fluctuations.
  • Company-specific risk: If an investee company becomes insolvent, investors may lose all of their invested capital.

To the extent that these materials contain statements about the future, such statements are forward looking and are subject to a number of risks and uncertainties and are not a guarantee of future results/performance.

Source: Credit Suisse, unless 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.

This material constitutes marketing material of Credit Suisse Group AG and/or its affiliates (hereafter "CS"). This material does not constitute or form part of an offer or invitation to issue or sell, or of a solicitation of an offer to subscribe or buy, any securities or other financial instruments, or enter into any other financial transaction, nor does it constitute an inducement or incitement to participate in any product, offering or investment. This marketing material is not a contractually binding document or an information document required by any legislative provision. Nothing in this material constitutes investment research or investment advice and may not be relied upon. It is not tailored to your individual circumstances, or otherwise constitutes a personal recommendation, and is not sufficient to take an investment decision. The information and views expressed herein are those of CS at the time of writing and are subject to change at any time without notice. They are derived from sources believed to be reliable. CS provides no guarantee with regard to the content and completeness of the information and where legally possible does not accept any liability for losses that might arise from making use of the information. If nothing is indicated to the contrary, all figures are unaudited. The information provided herein is for the exclusive use of the recipient. The information provided in this material may change after the date of this material without notice and CS has no obligation to update the information. This material may contain information that is licensed and/or protected under intellectual property rights of the licensors and property right holders. Nothing in this material shall be construed to impose any liability on the licensors or property right holders. Unauthorised copying of the information of the licensors or property right holders is strictly prohibited. This material may not be forwarded or distributed to any other person and may not be reproduced. Any forwarding, distribution or reproduction is unauthorized and may result in a violation of the U.S. Securities Act of 1933, as amended (the “Securities Act”). In addition, there may be conflicts of interest with regards to the investment. In connection with the provision of services, Credit Suisse AG and/or its affiliates may pay third parties or receive from third parties, as part of their fee or otherwise, a one-time or recurring fee (e.g., issuing commissions, placement commissions or trailer fees). Prospective investors should independently and carefully assess (with their tax, legal and financial advisers) the specific risks described in available materials, and applicable legal, regulatory, credit, tax and accounting consequences prior to making any investment decision.
Copyright © 2022 CREDIT SUISSE GROUP AG and/or its affiliates. All rights reserved.

Management Company (Fondsleitung): Credit Suisse Funds AG1, Uetlibergstrasse 231, CH-8070 Zurich I Custodian, Distributor: Credit Suisse (Switzerland) Ltd., Paradeplatz 8, CH-8001 Zurich I Distributor: Credit Suisse AG, Paradeplatz 8, CH-8001 Zurich I Distributor: Credit Suisse Asset Management (Switzerland) Ltd., Kalandergasse 4, CH-8045 Zurich I Language versions available: German, English, French, and/or Italian I Supervisor (Entity of Registration): Swiss Financial Market Supervisory Authority (FINMA)
1 Legal entity, from which the full offering documentation, the key investor information document (KIID), the fund rules, as well as the annual and bi-annual reports, if any, may be obtained free of charge.