Convertible bond funds post good performance despite concerns, Fitch

Convertible bonds (CB) have become an appealing and more mainstream asset class which can provide attractive risk-adjusted returns, even if they present technical risks that fund investors need to be aware of, warned today rating agency Fitch Ratings.

Global convertible funds have returned an annualised 9.5% over the past three years, approximately the same return as global equity but with 50% of the volatility, based on Lipper data.

However, Fitch said, over the past three years those funds have captured more of the market downside and less of the market upside than expected, which may point to greater credit sensitivity, notably in high yield.

“The asymmetric return profile, or CB funds’ ability to capture equity upside and protect against equity price falls, claimed by the industry is overstated for certain funds. Lower CB issuance has led to a stagnating market, while long-only ‘buy-and-hold’ institutional investors have generally replaced hedge funds as convertible bond holders since the collapse of Lehman,” Fitch added.

This has resulted in less liquidity and more mispricing on certain segments of the market.

“Fund investors need to focus on four areas when selecting and monitoring a CB fund: yield, convexity and overall risk profile; management of liquidity and supply constraints; management of market sensitivities and the ability to draw on multiple resources and inputs,” said Manuel Arrive, senior director in Fitch’s fund and asset manager rating group.

He added that a reduction in the amount of CBs available for investment, currently around €400bn globally, resulting from lower issuance is becoming a concern, particularly in Europe. Capacity and concentration are two risks that investors need to be aware of in this context.

Yield and convexity are two characteristics of CB that make them attractive in the current market and that asset managers focus on in their bottom up analysis.

In Fitch’s opinion, yield analysis relative to credit quality requires strong credit skills, notably as high yield, unrated and small caps names are growing in importance in the CB universe.

Maintaining convexity also requires discipline in portfolio selection. While bottom-up analysis is the essence of CB investing, certain funds could gain from a more tactical, dynamic management of delta with a short-term investment horizon.

“Global CB funds have seen net inflows of over €2bn year to date, offsetting outflows from European funds. Overall, convertible bond fund AUM has stabilised above pre-Lehman levels at €55bn,” Fitch said.

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