Convertibles stand their ground amid financial ‘repression’, says Jupiter’s Miles Geldard

Miles Geldard, co-manager of the Jupiter Strategic Reserve fund, says convertibles remain attractive at a time when central banks continue to press down yields on fixed income instruments.

You do not have to be convinced that central banks are quietly intent on financial repression to know they have made it increasingly painful for investors to hold cash, while the combination of inflation and abnormally low interest rates means the real return on deposits, gilts and many other “safe” sovereign bonds has been negative for a long time. Yet few alternatives look attractive.

However, there is one asset class which offers opportunities in difficult times – convertibles, i.e. bonds that can be converted into equities. The structure of a vanilla convertible is a corporate bond embedded with an long-maturity equity call option. When the price of the equity is low the convertible behaves like a corporate bond and, when high, like an equity.

The middle ground between the bond area and the equity area is where convertibles become interesting. This is where convertibles exhibit their true hybrid nature because value begins to be found in the embedded options. Convertibles have convexity, a unique attribute which offers an attractive asymmetric risk/return payoff by providing the upside potential of equities with the downside protection of corporate bonds.

Convertible bonds are of interest to investors because historically they have provided superior risk-adjusted returns to either bonds or equities over complete market cycles, with much of this outperformance coming during down markets.

But if markets are efficient, how can this be? The answer is twofold: convertibles are often mispriced and they tend to be issued too cheaply. The mispricing can arise because different investors place different emphases on the features of convertible bonds.

Many convertibles are unrated by credit rating agencies, as companies seek a quick, cost-effective way to raise capital. With the burden of analysis falling squarely upon the investor, it can be an advantage to have an experienced and proficient team to assess the huge variety of convertible bonds in issue.

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