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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
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.
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.
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
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
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.
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