Asymmetrical’ benefits of convertibles touted as solution to market uncertainty

Jupiter Asset Management and Lombard Odier are among managers noting the benefits to investors of convertible bonds, which could enable them to take advantage of rising equity markets while avoiding the downside risks of an uncertain investment climate.

Lee Manzi (pictured), fund manager for Jupiter Asset Management’s fixed interest and multi-asset team, puts it succinctly: “Investors have a dilemma. On the one hand, major parts of the global economy are on the verge of recession, while on the other we have unprecedented levels of monetary and fiscal intervention.”

Central banks having been pushing down government bond yields, making them less attractive and consequently forcing investors into riskier assets with better returns. What has been called ‘financial repression’ cannot continue forever, since the intervention becomes less and less effective over time.

Portfolio positioning

The unusual policy measures are essentially a stop gap until necessary structural changes can be effected and economies coaxed back to growth. But in the meantime, how should investors position their portfolios?

“One option is to consider assets that have the potential to offer asymmetric returns,” says Manzi. “We consider convertible bonds offer such a proposition. The asymmetry comes from investors receiving the payment of the coupon and the value when the bond matures [principal] while at the same time having an option to convert into shares. This offers the potential to benefit from rises in the share price while theoretically limiting the fall in the convertible price.”

Ideally, convertible investors capture progressively more of the rise if the underlying equity moves up and progressively less of the downside if the equity falls.

Convertible bonds returned 7.4% (UBS Global Convertibles index dollar un-hedged) on average each year between 1994 and 2012, versus 5.3% for equities (MSCI World dollar un-hedged index) and with significantly lower volatility.

But the convertible bond market contracted in recent years as subdued equity markets and ultra-low government bond yields resulted in lacklustre issuance.

Convertibles allow companies to issue debt more cheaply compared to the straight bond market, in exchange for offering an option to convert to shares.

However, record low nominal yields have removed much of this relative funding advantage.

In the second half of 2012, equity markets and government bond yields rose, resulting in a pick up in convertible bond issuance. “If government bond yields continue to rise, we should see more new issuance and investment opportunities in the convertible bond market in 2013,” says Manzi. “To us, a rise in bond yields seems likely as they are currently close to historic lows.” 

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