With market uncertainty rife, the risk of equities and bonds falling together has rarely felt greater. As an asset class, convertible bonds are probably one of the most under-owned in investors’ portfolios. To recap briefly, convertibles are corporate bonds with an embedded equity call option. And in theory, an asset that benefits from the growth potential of equity with capital preservation attributes of bonds should enhance a portfolio’s risk-adjusted return. Historically, convertibles are highly correlated to equities. Yet the risk/return profile of a convertible has proven to cushion negative returns during periods of equity drawdown.
The theory…
The key argument for why convertibles help improve risk-adjusted returns is with the asymmetric payoff they can provide. In a rising equity market, selling out of bonds that start to exhibit a more equity-like return profile, and buying into more convex “balanced” bonds, ensures a downside cushion is upheld, while locking-in gains. In falling markets, there are more opportunities for managers to invest in previously equity-like bonds that have fallen significantly in price and have become more convex. Where active portfolio managers add value is identifying credits that are not going to default on their coupons and pricing points when a bond should be traded.
… And the reality
Many investors will highlight how the asset class performed in 2008 and question the proposition. The MSCI World returned -41% in 2008 versus the Thomson Reuters (TReuters) Global Convertible Bond index (-32%). Although outperforming, the 80% downside capture was huge.
The issue here relates to investor-type. Historically, convertible bond investors were investment banks and hedge funds. Given that convertibles are hybrids of separately available equities, supply/demand dynamics mean that there are opportunities to take advantage of arbitrages. As these strategies became more popular pre-financial crisis, the ability to generate meaningful returns diminished. Hedge funds overcame this by leveraging up trades. Thus, post-Lehman’s demise, trades were quickly unravelled as hedge funds had to meet redemptions. Indeed, October and November 2008 saw convertible valuations plummet below their conventional equivalents. The loss generated in 2008 does not mean that arbitrage investors no longer exist. But where the market was severely overleveraged in 2008, it is acknowledged that today it is predominantly made up of long-only active managers. Unsurprisingly, convertibles’ issuance has been on a downward trajectory up to 2012. There are now roughly 2,000 issues with a market size of is around $400bn. Compare that with US high yield, which is roughly three times as large, or the conventional bond market with around $14,000bn, one could be forgiven for thinking the market size and implied liquidity is too small for consideration.
Bond diversification
Until the option to convert is exercised, convertibles are still a coupon paying instrument that generally rank pari-passu with unsecured corporate bonds. While their long-term relationship with sovereigns is low, the relationship with other fixed income assets, as credit risk rises, is what investors should be mindful of, high yield especially.
