Because convertible bonds combine the features of fixed income securities with equity optionality, their returns are driven by factors that influence the performance of both asset classes, although convertibles have historically tended to exhibit the closest correlation with equity markets.
Benefitting from their significant participation in the rise of global equity markets in 2013 and the first half of 2014, the global convertibles market has performed strongly in recent years. As a result, the average equity sensitivity of convertibles has increased and investors must now be more selective in order to secure an attractive yield. That said, over one third of the bond-like space has a ‘yield to best’ greater than 4%, providing an attractive yield combined with equity optionality which could prove valuable should the equity perform.
The equity rally meanwhile has fuelled a resurgence in the primary market, which makes issuing convertibles at a premium to the current stock price ever more attractive for issuers. This has been further supported by an upturn in merger and acquisition activity, since convertible issuance may be used for financing, as well as concerns of an imminent increase in interest rates, which provides a spur for companies to issue debt in advance at lower rates.
Expanded opportunity set
The increased equity sensitivity of the convertibles market, combined with strong primary issuance, has fundamental implications for balanced and income-focused convertibles investors. Both factors have driven a significant recovery in the number of convertibles considered to be balanced, suggesting that balanced funds are better placed than at any point in the past three years to build diversified portfolios offering defensive participation in equity market returns.
The expanded opportunity set has also made it possible for income-focused accounts to allocate more to balanced convertibles, particularly those issued by small and mid-capitalisation issuers where the coupon tends to be highest. This has enabled income-focused funds to support the yield generated whilst adding incremental equity sensitivity at a time when equity markets have performed strongly.
Finally, to the extent that demand remains strong and in the absence of some kind of exogenous market shock that reduces risk appetite, the recent improvement in valuations back to fair value could be considered to indicate an attractive point at which to consider an investment in convertibles.
