Geopolitics play an increasingly important role in financial markets but the outcomes of the events on the geopolitical agenda are often the hardest to predict. 
The ongoing debate about the UK’s exit from the EU and the policies of the US president Donald Trump’s administration as well as the rise of populist parties globally remain amongst the top drivers of asset prices. Foreign policies, trade wars and elections could have significant positive and negative effects on traditional stock and bond portfolios, making it challenging for investors to remain invested but also consistently maintain a level of protection for their capital.
While periods of political chaos aren’t a new phenomenon, one asset class that has successfully weathered multiple bouts of volatility and has been gaining new popularity within the investment community is convertible bonds.
Efficient diversifiers of credit and equity portfolios alike, convertible bonds combine both corporate bond and stock characteristics.
Issued by listed companies, these bonds are particularly appealing as their embedded equity call options allow investors to profit in favourable politico-economic scenarios, while their coupons and fixed redemptions provide a floor when fear and uncertainty persists or negative outcomes materialise.
In most cases, convertibles follow an asymmetrical pattern as they increase more in value than they drop when the companies’ share prices go up or down by the same amounts. Within the credit risk spectrum, the bulk of the convertible universe typically sits in the crossover segment between investment grade and high yield-type credits (BBB-BB). Convertible bonds also exhibit a negative correlation to government bonds and therefore tend to decrease a portfolio’s interest rate risk.
Therefore, convertible bonds on average carry less credit and interest rate risk than many other credit products. The advantages of the asset class have been proven historically as convertible bonds have delivered one of the best risk-adjusted return performances from the major financial asset classes since the beginning of this century. Low duration and equity upside with less risk are particularly relevant features in the current economic backdrop, characterised by positive growth, rising interest rates and increased volatility driven by geopolitics.
Many listed companies choose to issue convertible bonds as an attractive way to raise capital – they pay lower coupons than other equally-ranking bonds in exchange for the valuable stock options that investors receive. As US interest rates have been rising, convertible bonds have become more attractive and issuance has picked up as companies are trying to save on interest costs. In fact, 2018 convertible bond issuance volume has been the highest in the US (at over $50bn) and one of the highest globally (circa $85bn) since before the global financial crisis.
The phasing out of monetary stimulus measures in Europe is likely to boost convertible issuance further in the future. Meanwhile, interest in the convertible asset class has also been picking up on both sides of the Atlantic as investors search for alternatives to de-risk their portfolios while maintaining meaningful exposure to markets.
For investors, the recent surge in convertible bond issuance provides a wide range of opportunities within the market, especially in companies which have no other investable debt. Those companies are often fast-growing disruptors within their own industry, such as cloud communications innovator RingCentral or genome sequencing pioneer Illumina. Such businesses are driven by strong secular trends which provide some insulation for earnings in the medium term against geopolitical volatility and broader cyclical downturns. Yet, the share prices could be quite volatile as it is the norm for growth stocks to overreact to short-term changes in market sentiment.
The bond elements of a convertible could shield investors from a significant part of the realised share volatility while the higher expected volatility increases the value of the option and the convertible bonds, all else being equal. It could be argued, therefore, that convertible bonds are a much more risk-efficient way for investors to retain equity exposure than stocks.
There is one caveat, however: the convertible bond part would only protect investors and dampen volatility as long as it holds onto its own value which is driven by the perceived credit-worthiness of the company. Luckily, quite a few convertible bond issuers’ credits benefit from clean balance sheets, low leverage and stable cash flows. Nevertheless, rigorous credit analysis performed by an active manager is of utmost importance for investors seeking adequate protection for their capital, especially given that the majority of convertible bonds are not rated by the main credit rating agencies.
Nobody knows for certain what would be the resolution of today’s main political conundrums or where financial markets will be heading in the next few months. What is certain is that many businesses and economies remain on the path of strong growth. The US Federal Reserve also seems determined to continue to tighten monetary conditions as the real (adjusted for inflation) interest rate is still near zero. With asymmetrical returns, low interest rate risk and a surge in issuance, convertible bonds are well positioned to offer investors an efficient way to remain invested in economic growth and navigate geopolitical storms.
Ivan Nikolov is a senior portfolio manager at NN Investment Partners. The views expressed above are his own and should not be taken as investment advice.