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The growing opportunities in an overlooked asset class | Trustnet Skip to the content

The growing opportunities in an overlooked asset class

27 June 2019

RWC’s Justin Craib-Cox says strong convertible bond issuance globally, coupled with supportive fundamentals, has left the asset class in a rare and unique position to deliver returns.

By Justin Craib-Cox,

RWC Partners

Uncertainty brings risks, but it can also bring opportunities, particularly for convertible bonds.

In recent years markets had seemed eerily calm, but now volatility and uncertainty are constant features on the geopolitical, economic, and company-specific fronts, sometimes all at the same time.

In our experience, periods of rising volatility and non-trending markets are where ‘convexity’ brings the greatest benefit from convertible bonds to portfolios. This is because convertibles – hybrid instruments that behave like both debt and equity – have embedded conversion options that give holders the right to convert into equity, usually after the stock price has risen by a pre-set amount. When volatility rises, the value of the embedded option may increase, giving investors upside exposure to rising markets; at the same time their convexity offers investors downside protection (as the bond will return capital if held to maturity) if the underlying stock price falls.

As such, convertible issuers can offer exposure with good downside protection to more growth-focused stocks and regions. Holding exposure to more growth-focused stocks through a convertible allocation reduces downside risk compared with holding those stocks on their own. In addition, in a low-rate environment that is causing investors to stretch for yield, convertibles can help provide diversification to a fixed income allocation without accepting more credit or duration risk.

The asset class looks inexpensive now given that realised volatility has been on the rise.

So what issues can convertibles help to solve for investors right here and now?

 

The known unknowns

Looking from the top down, markets and politicians are worried about slowing growth. That said, most convertible issuers are more growth-focused than the broad market, mainly because convertibles are an efficient way to raise capital for reinvestment or for projects where the opportunity cost is close to that of equity. While growth stocks have been outpacing the broader market in terms of gains over the past several years, higher top- and bottom-line growth won’t guarantee these issuers’ stock prices will keep rising. But we think that holding exposure to growth companies via convertibles, where the bond component preserves capital if the underlying stock price were to fall, provides better protection versus holding their equities alone.

It is also clear that we face high uncertainty on the macro front, particularly around trade wars and Asia. Convertibles offer a way to take a view on expected outcomes, but with convexity and downside protection if the view doesn’t play out. Take as an example the threat of a trade war between the US and Asia. Some issuers could see a major impact either way if tariffs increase or are scrapped, but the structure of convertibles allows us to measure the upside and downside impact for a given move in the stock price. By focusing on convertibles that structurally give more upside participation than downside risk, we can take a view – as an example – that might assume we get a reasonable solution to a trade agreement, and without suffering volatility and drawdowns along the path to that resolution.

 

Fixed income investors face another challenge with historically unprecedented levels of tightness in credit spread and negative yields on government debt. These conditions cannot last indefinitely. Compared with other bond markets, convertibles are generally shorter duration and issuers range from investment grade to high yield, although we keep our portfolios investment grade on average and avoid CCC-rated issuers. As such, convertibles have a similar return and volatility profile to high yield, but without the associated credit or duration risk.

 

New issuance, new opportunities

New issues provide us with more names to consider, as well as replacements for holdings that have become too bond-like or equity-like.

As a global market, convertibles are roughly $400bn in bonds outstanding. In our view, this makes convertibles a more specialist area that is under the radar of passive and algorithmic strategies, but still broad enough to provide diversification by region, sector, and issuer. The specialist nature of our market also means that new deals generally must be priced in an attractive way to ensure interest from investors.

So what kind of companies issue convertible bonds, and why? It depends slightly on the region, but issuers from higher-growth sectors will often consider convertibles for their financing needs, rather than straight debt that might bring constraints. Convertibles can also bring flexibility to issuers; for example, the ability to bring non-rated bonds to the market, or simply to reduce coupon expense. Still, convertibles are usually ranked the same as senior unsecured corporate debt.

Given that rates in the US began to tick upwards in 2018, the last calendar year saw the highest level of issuance for new convertibles since 2014. This increased level of activity came from across the globe, but was tilted towards the US as well as Asia, where many issuers’ funding costs are effectively dollar-linked. We have seen this activity persist into 2019 and note that many companies that have recently gone through the IPO process may well have additional funding needs for growth that a convertible could help to address.

 

Finally, the technicals

When we say that valuations for convertibles are attractive, or that optionality is cheap, what do we mean?

Investors familiar with the asset class will know that the price of an embedded conversion option can be compared against listed options. Essentially, by looking at the implied volatility of an option compared against the forecast volatility of the underlying stock, when implied volatility is low, the option is technically cheap.

There are a few reasons why an embedded option might trade cheaply, including supply versus demand for the convertible itself, as well as changing volatility forecasts. At present, convertibles are modelling cheaply, or to put it another way, the embedded option to convert doesn’t cost much if we are in for higher volatility. Cheap optionality may not be the major source of future expected returns, but it can present a good opportunity for allocation.

 

Justin Craib-Cox is co-manager RWC Defensive Convertibles fund. The views expressed above are his own and should not be taken as investment advice.

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