Attractive pricing and low volatility boost convertibles

French convertible bond fund managers suggest that the asset class currently offers good entry points despite facing losses during the first half of the year.

According to data consultant EuroPerformance, assets managed in France-domiciled convertible strategies reached €14.5bn at the end of June 2016.

The asset class recorded a 0.9% drop in AUM with outflows of €421m over the second quarter of 2016 and total assets managed as at 30 June 2016 were down 19% since the beginning of the year.

Hubert Lemoine, head of Convertibles at Schelcher Prince Gestion, estimates France-domiciled convertible funds have seen an average 10% decrease in assets under management during the first half of the year.

“We have been impacted too. We stress that convertibles have behaved as an absorber but when markets drop, investors exit the asset class to invest directly in equities.

“Also a loss of confidence in eurozone forecasts can lead investors to reduce investments focusing on the eurozone and go global in order to gain diversification as well as to avoid regionally inherent risks such as Brexit,” he says.

Despite losses, French convertibles fund managers express confidence in the attractiveness of the asset class. Amid arguments, the prices of convertible bonds are currently cheap and the asset class shows low volatility.

Denis Passot, senior convertible bond portfolio manager at Natixis Asset Management, highlights that recent times have shown convertible bonds remain an exposure to equity with lower volatility.

“The low level of the price of the underlying convertible bonds and the valuation of the asset class make it an attractive tool for investors. The implied volatility has effectively reached a historical low level at 25%.”

He also notes that diversification in terms of issuers and sectors has become richer.

According to Brice Perin, head of Convertible Bond Portfolios at Generali Investments, investors can currently find a good entry point into the convertibles market as implied volatility has dropped by 5%-6% on average for the past six months.

“Valuations now appear lower and more attractive, being only 1% or 2% above those registered during the volatility crash of October 2014. That favours a comeback of investors in the market,” he points out.

Perin says the drop in volatility has helped to cut prices of most convertible bonds compared to other market periods.

“Brexit has caused a dispersion in the market between the investment grade and the high yield segments. The investment grade bucket showed resilience as volatility slipped by 0.5 to 1% on average.

“Convertibles with higher delta like Deutsche Post and Cap Gemini have even seen an increase in their valuations while bond floors have dropped significantly in the high yield segment.

“It is a repeat of events we have seen in January-February this year. We try to hold convertible bonds that have the most stable profiles,” he explains.

Lemoine also stresses a drop in the pricing of convertible bonds and adds the recent market correction has had little impact on their deltas.

“Some 20 investment grade convertibles have a delta standing at 30 to 40 with an implied volatility of 30%. Investment grade convertibles are not the cheapest neither the most valuable but it is still interesting though to have good quality credit.

“The convertible universe can draw investors as in a low-rate environment, it allows them to switch from bonds to equities in a secure way,” he underlines.

Lemoine calls lack of issuance an issue in the US market, which explains, he says, valuations of US convertible bonds standing at reasonable levels with an implied volatility of 40%, while that of European convertibles bonds stands at 28%.

Natixis’ Passot assesses that the decreasing issuance has not been as worrisome as expected. He says that the sharp fall in equity markets at the start of 2016 led many companies to postpone issuance before coming back in a friendlier environment.

“As of end June, 23 companies issued bonds totaling €10.5bn against €12.5b over the same period in 2015. But at the same time redemptions, notably earlier this year, have been high at €11.5bn. Consequently, the net amount is currently negative,” he argues.

Also Passot stresses that the primary market has evolved in terms of new issuers and new structures as lots of blue chip companies issued non-dilutive bonds in stretched conditions.

A convertible bond is considered non-dilutive when the issuer simultaneously buys back the underlying option of the convertible to hedge against a share dilution risk.

Generali Investments’ Perin explains that if it is fair to say that new issuance of convertible bonds have struggled a little in the US market since the start of 2016, this is not exactly true for Europe.

“2015 was the highest new issue year since 2009. Furthermore, some €15bn of convertible bonds have been issued since the start of 2016. Therefore, we do not have concerns for the rest of the year as the amount of bonds that will be redeemed or are likely to convert remain limited with less than 5% of the convertible market capitalisation between now and year-end,” he explains.

Perin says major investment grade companies have come back to the convertibles market by issuing non-dilutive convertibles that have driven the market in the past few months. The suggestion is that they feel it offers an appealing source of funding.

Lemoine does not share the same appetite for non-dilutive convertible bonds.

“The recent issuance of non-dilutive convertible bonds did not seem appealing to us as a number of investment grade issuers were simply arbitrating the appetite of convertible fund managers. Issuances of convertibles were much needed at the end of 2015 and earlier in 2016 but the issuance of non-dilutive convertibles did not correspond to any new investments or restructuring done by companies. That was only financial arbitrage,” Lemoine argues.

Other reasons to dislike non-dilutive convertible bonds include an absence of classic ratchet clauses and protection around dividends.

All three managers believe the equity component will remain a significant performance driver in the second half of 2016.

“Regarding the low level of the yield and the spread, notably investment grade spread, this factor shouldn’t be a key support of the performance. It is difficult to expect bigger tightening in terms of spread. Nonetheless, high yield names will carry on running yield.

“To a lesser extent the low valuation of the asset class should support the performance. The implied volatility could increase by 5 points to reach the 30% historical fair level,” Passot says.

Perin adds that in 2015, equities and credit drove around 75% and 5% of the performance respectively in the convertible space.

“The remaining 20% was driven from changes in terms of implied volatility. We believe that this trend will persist.”

On the fund buyer side, Marc Terras, CIO of Rothschild HDF Investment Solutions, assesses that the amount of volatility investors will face in coming quarters makes convertibles’ low volatility – compared to equities – a key asset in portfolio asset allocation.

“On a global note, the solvency capital requirements needed by insurers to be compliant with the Solvency 2 framework make the asset class really attractive,” he says.

According to him, the bond component of convertibles should not penalise the performance of the asset class over the short term in the current low rate environment.

He says that in regards to the “bright perspectives” offered by the global economic cycle, primarily in the eurozone, convertibles appear appealing and should benefit from their equity component.

Nicolas Moussavi, head of Mutual Fund Research at Lyxor, points out that despite current interesting entry points in the asset class given the low level of implied volatility, the company is not fond of convertible bond funds over the long term.

“In general, the performance depends on the delta level of the fund. The behaviour looks like a diversified fund which consists of a mix between equities and bonds with a “pre-desired” level of equities.

“In addition, there are some biases that investors have to keep in mind like non rated bonds, and a lot of mid cap and tech issuers,” Moussavi comments.

This article was first published in the September issue of InvestmentEurope that can be downloaded for free on

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