Convertibles have had a rough ride so far in 2022, but we think there’s reason to expect a smoother road.
We expect convertible bonds to be well positioned to outperform other fixed income assets if rates continue to rise.
As has been well documented, risk assets have come under severe pressure this year as central banks around the world attempt to stamp out inflation by tightening financial conditions. Convertible bonds were not immune to this weakness. Normally, at this stage of the cycle – with rising rates and volatility remaining high – convertibles would be an intuitive choice, in our view. Despite current market conditions, we believe the timing is no exception.
First, with the lowest duration among the major fixed income asset classes (not only now but also historically, as shown in Chart 1), we expect convertible bonds to be well positioned to outperform others. fixed income assets if rates continue to rise to combat persistently high inflation.
Figure 1. Duration of selected bond indices
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Source: Bloomberg; as of June 30, 2020. Indices used: Global convertible bonds – VG00; Global Investment Grade – G0BC; Global High Yield – HW00; Global Government Bonds – W0GI.
It is the only part of the bond market that is not structurally short on volatility.
Second, given the high macroeconomic uncertainty, equity volatility continues to rise (Chart 2). This ultimately supports convertible bond valuations, in our view, as it is the only part of the fixed income market that is not structurally short on volatility, thanks to its embedded call option which helps compensate investors for a coupon often lower than that available in traditional markets. obligations.
Figure 2. VIX Index
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Source: Cboe; to July 19, 2022.
In addition to these structural tailwinds, we believe there are tactical reasons why convertible bonds could be an attractive prospect for investors at this time. For starters, the sharp sell-off in risky assets that began in late 2021 ranks among the largest market declines in history; we are now in a position where starting valuations have been significantly lowered. Additionally, the convertible market has been reshaped by this, with high-growth-focused stocks that have dominated primary market activity since 2020 being the hardest hit by rising rates and broader macroeconomic weakness. These primary transactions, which came with record coupons and conversion premiums in 2021, saw their bond prices fall dramatically in unison with their underlying stocks. Many are trading below their originally traded bond floors due to their high sensitivity to rising rates and widening credit spreads.
Convertible bonds are currently trading at historically high levels of cheapness.
Such a glut of new paper over the past two years (Chart 3) has been positive for the asset class in the sense that it has certainly raised its profile and diversified the borrowing base into new sectors, but an effect negative was that market indigestion caused some significant decline in the secondary market. However, we believe this now presents opportunities for investors as convertible bonds are currently trading at historically high levels of cheap relative to fair value.
Figure 3. Primary issuance of convertible bonds
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Source: Bank of America Merrill Lynch; as of June 30, 2022*
The opportunity set is the most convex in many years.
So, with equity valuations having corrected sharply, the convertible bond asset class is much more balanced, in our view, with less exposure to high growth stocks. Investors are still able to maintain upside exposure to these names, but with convertibles now trading much closer to their bond lows on average, the opportunity set is the most convex it has been in many years. many years. Indeed, based on the last 20 biggest declines in the US stock market, data from Bank of America Merrill Lynch shows that over the following three, six and nine month periods, US convertibles rallied on average. 9.3%, 12.5% and 20.6%. % respectively.1
Convertibles are an oversold asset class within a broader credit market that we believe is itself oversold. Adjusting for the differences in volatility between equity and credit markets prior to this current decline, our analysis indicates that credit markets have experienced a correction twice as large as that experienced by equity markets.
Interestingly, as a result of this normalization, with bonds trading closer to their lows, a historically large portion of the market is classified as “busted” with the embedded equity option deep out of the money. (in the left part of figure 4).
Figure 4. Illustrative profile of a convertible bond
Source: Man Group. For illustrative purposes only.
These broken convertibles, many of which are in the 2020 and 2021 classes, underperformed their theoretical downward deltas. In theory, at current levels, they should trade more like a traditional bond. History suggests, however, that these are the same bonds that are poised to outperform when markets rally and investors seek to take advantage of their attractive yields and upside option. Also, when strategists start to revise growth expectations down (as they do now), it’s usually when growth sectors started to perform historically. Convertible bonds can expose investors to this dynamic.
Most of the asset class is now trading with positive yield at worst.
As for yields, with such a large amount of convertible bonds in crashed territory, most of the asset class is now trading with positive yield at worst – despite headlines depicting zero or very low coupons. Indeed, there are many cases where convertibles trade much wider than the spreads of comparable ordinary debt (even from the same issuer). This could provide some very attractive opportunities for traditional fixed income investors looking to diversify into convertibles, as they are able to gain exposure to companies with either higher upside potential or simply companies that are not active in other parts of the fixed income universe. . Most convertible issuers only have convertible debt on their balance sheets, for example.2
After exceptional issuance levels in 2020 and 2021, there is no impending maturity wall for convertible issuers to worry about; in general, we consider them to be well placed from a liquidity point of view. Indeed, according to data from Bank of America Merrill Lynch in June, about two-thirds of the market is not expected until 2025 or after. There is therefore plenty of time for markets to stabilize before companies need to refinance. And as mentioned, with most convertible issuers having only convertible debt on their balance sheet, convertible investors have complete control over their capital structure. Additionally, while some have suggested that primary activity has been subdued this year due to companies’ inability to access capital, we believe this is more reflective of a current reluctance to tap into the primary market following activity. massive funding rounds in 2020 and 2021. which has left companies in a favorable position.
Even if we find ourselves in a recession in the short or medium term, we believe that the decline will be more limited than in the past. First, we have seen a wave of defaults in 2020 and, in essence, the time since the previous downturn has been too short. Companies have not had time to get out of their cautious attitude and therefore have not yet reached excessive levels of indebtedness. Evidenced by the low levels of activity in the major bond markets this year, with companies remaining happy to sit on their existing cash. Second, inflation means that companies are able to deleverage even in recessionary environments. Debt is fixed in pre-inflated terms while their income (and profit) is in nominal dollars. These two factors make us confident that default rates will not reach their normal cycle peaks of 12-15%.
Convertible investors typically see large gains in mergers and acquisitions because the built-in ratchet mechanism increases the terms of conversion.
A final point worth highlighting is that takeover activity has been high in the convertible space this year, after 2020 and 2021 were all about strengthening balance sheets. We expect more of these oversold companies (with good products but weak or negative earnings) to be acquired by their larger competitors or strategic buyers. In particular, companies rated investment grade may seek to use their significant additional debt capacity to finance their organic growth, while remaining in the investment grade bracket. Recent examples include the acquisition of US software company Zendesk by an investment consortium for five times forward sales and the acquisition of video game developer Zynga by Take-Two. Convertible investors generally see large gains in mergers and acquisitions, as the built-in ratchet mechanism increases the conditions for conversion, while conversely, investment grade approaches may see the negative impacts of this trend.
1. Source: Bank of America Merrill Lynch, June 2022.
2. Source: Bank of America Merrill Lynch, June 2022.