Cracking the Convertible Bonds enigma

Returns from fixed income in the next five years are unlikely to match those of the last five years. The market volatility that we have seen in the last five quarters has however further reinforced the case for convertible bonds (CB) as part of portfolio diversification. The enigma for me is why CB’s seem to remain outside the peripheral vision of such a large number of institutional investors?

The investor base in convertible bonds has changed materially since the financial crisis of 2008. Outright investors are now dominant, while the influence of hedge funds and proprietary trading desks has declined significantly. This development has substantially reduced the risk of events of 2008 repeating themselves in the CB market. Such a repeat is the only evident potential bear case for CBs, in our opinion. At this moment though, one cannot dispute the portfolio diversification qualities that CBs do deliver. This is particularly substantiated by its great historical performance, with one of the highest risk adjusted returns of any traditional asset classes.

In our opinion, CBs are an excellent vehicle to navigate through uncertainty with as they have performed well in numerous investment cycles.  A CB will offer good equity participation, combined with downside (bond floor) protection. The resulting convexity enables investors to participate in two-thirds of the upside of the underlying equity and one-third of the downside. Through challenging economic cycles, CB’s will be a powerful portfolio diversifier.  As such, our investment philosophy is to maximize equity participation per unit of risk, based on four aspects:

•              CB structure;

•              capital preservation/credit;

•              equity upside drivers identified within our theme selection;

•              portfolio scaling and risk control.

The two largest themes that we have currently in the portfolio are cloud computing and healthcare spending. We believe that the segment of cloud computing – shared on-demand computer resources and data – will continue to grow exponentially, as it brings cost and speed efficiencies to businesses and individuals alike. Similarly, we are confident that growth in healthcare spending will continue to outpace GDP growth in developed economies, given the increasing demands of the ageing population.

We have avoided the oil and gas sector, where we expect instability to persist in the medium term. From a regional standpoint, we have not been investing in companies in China and certain other emerging markets. The lack of corporate governance transparency in these markets has limited our confidence in the downside protection – a key consideration in our process.

CB’s offer a bridge between equity markets and fixed income. They have performed very well in rising interest rate environments; they have also historically performed well in low-yielding environments, as has been seen in Japan. Convertibles, for example, have a negative or very low correlation to sovereign and investment grade bonds. Their correlation to High yield is 60% and to equities is 92%. Balanced convertible bonds have thus a better risk-adjusted return on offer for investors than other traditional asset classes.

In this context, “balanced” convertibles refers to CBs in their purest sense, as opposed to convertibles with conversion prices significantly above or below the underlying share price. The term “balanced CBs” also excludes mandatory CBs, which are  converted into equity at maturity , and so-called synthetic CBs, which usually consist of a combination of bonds and warrants.

Whatever the context though,no one can argue the portfolio diversification qualities that CBs do deliver.

Tarek Saber, head of Convertible Bonds at NN Investment Partners

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