Convertible bonds are often touted as a suitable late cycle investment as they provide upside exposure to equity markets with some downside protection from fixed income, but investors are concerned that characteristic may not stand due to the breakdown of the traditional negative correlation between the two asset classes.
While convertibles, which offer the option to convert into equity, are useful in volatile markets, this is “dependent upon a belief that bonds and equities have a negative correlation” which “may not be true currently”, according to Simon James, founding director at Gore Browne Investment Management (GBIM).
“I believe that the current market combines downside equity risk and an upward bias to interest rates,” he says. “In this environment I would prefer to wait until interest rates are closer to peaking.”
Tread carefully
Matt Brennan, head of passive portfolios at AJ Bell, says with the prospect of higher bond yields it is important to remember convertibles act much more like traditional bonds if equity markets fall. “As such, any investor moving into the asset class should tread carefully, understanding the exact bonds they are getting exposure to,” he says.
Given the relatively high correlation to equities, Rathbones head of collectives research Alex Moore says he would use them as part of an overall tactical asset allocation. “Those wanting a lower correlation to equities are unlikely to hold a material position,” he says.
Niche, complicated investment
Last Word Research has revealed that the asset class has been viewed mildly positively among UK fund selectors over the past two quarters and used by about 40% of respondents.
Source: Last Word Research
But according to Morningstar data collated by Last Word Research, net flows for convertible bonds show investors have been pulling out of the asset class for the past year.
Source: Morningstar/Last Word Research
James, who has small exposure to convertibles, says many people also don’t use them because they can appear complicated. “They prefer to make clearer asset allocation choices. The individual issues can lack liquidity too.”
Noelle Cazalis, a portfolio manager on the Rathbone Strategic Bond fund, says she owns 2.1% in convertibles in the fund via the RWC Global Convertible Bond fund, the RWC Core Plus fund and the NN L Global Convertible Opportunities fund.
But her colleague Moore says convertibles are still a niche investment, particularly in the UK.
“Essentially, these quasi-bonds and equities are used as portfolio ballast, to help control volatility,” says Moore.
“It’s all about positioning the convexity, meaning a skilled manager will be able to capture most of the upside and cushion on the downside. That means in any given year, you wouldn’t expect huge upside versus an index; having said that converts can generate meaningful risk-adjusted returns.”
However, he argues sometimes investors make the mistake of utilising convertibles as low beta risk.
Brennan adds that although there is a time and a place, AJ Bell does not use convertibles currently.
“A convertible bond is essentially just a bond plus a call option, so there is an argument for just doing this yourself – having a fixed income allocation and then equity derivative exposure.”
Alternative to derivatives
Elsewhere, Hector Kilpatrick, chief investment officer at Cornelian Asset Managers, says he has between 3% and 4% of its global, multi-asset portfolios invested in the Schroders ISF Global Convertible Bond fund.
“This position has been a long-term holding for us,” he says. “We consider the investment as part of our equity allocation, however we are attracted to the asset class and the fund in which we invest because of its asymmetry of returns.
“The strategic objective of the fund is to participate in 75% of equity market upside, while limiting drawdowns to less than 50% of equity market falls.”
Meanwhile, Brennan argues that convertible bonds are sometimes issued by companies where options cannot be bought, therefore offering new opportunities.
“Equally, some investors would rather not directly hold derivatives, so it allows them to get a similar return profile to a portfolio of call options without having to hold a derivatives agreement,” he says.
Kilpatrick adds that while the firm is constructive on the outlook for equities, believing that productivity in the US will surprise on the upside, he is also aware that first, “the consensus doesn’t share our view” and second, “we don’t have a monopoly on wisdom”.
“Therefore, an allocation to convertibles makes sense given the convexity of returns,” he adds.
