- Higher market volatility is bringing convertible bonds back into fashion with selectively attractive valuations.
- The protective qualities of convertibles have been tried and tested in recent years and look well placed given the array of risks and uncertainties in the world.
- Return potential remains strong with interesting opportunities in growth companies in the investment universe following solid 2019 issuance.
As we close out a fruitful year for financial markets, it’s fair to say that 2020 will not start with the same recovery potential as we saw at the beginning of 2019.
The market’s view of monetary and fiscal policy has also shifted. For 2020, it seems highly likely that central banks around the world will be supportive with lower interest rates, significant quantitative easing, and perhaps even other non-conventional measures from the central banks’ tool boxes. Moreover, governments seem prepared to start spending significantly more and the age of austerity really does seem over. Eventually, even Germany may lift its foot off the “Schuldenbremse” (debt brake).
On the other hand, geopolitical risk is abundant as ever, albeit ebbing and flowing. Like a lighthouse with its rotating spotlight, only parts of the rocky cliffs are in the news beam at any one time. Italian financials and the difficult budget situation light up, followed by China-US tariff wars, before the light moves on to Brexit in the UK. Then suddenly sluggish data from Germany, with a special focus on its car industry, or the economic slowdown in China, seem to dominate news. Just every now and then, our lighthouse beam does not light up any rocks or dangers at all, as was the case in 2019 when investors bought strongly in to the idea of the central bank put keeping the bull market going.
Our forecast for 2020 is that markets will be pulled between these two factors; bullish risk-on phases with sudden market jumps will be followed by sudden gloom. Hence, volatility will potentially be higher than this year.
What advantages could convertibles provide for your asset allocation?
We are reasonably sure that downside protection will work. There are three parts to this argument:
- The overall equity exposure in convertible bonds is at the lower end of the balanced spectrum and also low when we compare this to the last five years. Convertibles should generally come with lower downside risk. Moreover, we are tactically defensive and most of our strategies come with lower exposure compared to their benchmarks.
- In a market which has already seen strong equity gains where convertibles are up significantly, we usually notice a strong demand for the asset class – and hence higher valuations. Despite strong returns from the asset class in 2019, convertibles are fairly priced, in our view. European convertible bonds look expensive, but we continue to find some value in regions such as Japan and Asia. When securities are already trading on fair valuations, this adds another cushion against a potential re-valuation should markets decrease.
- Convertible bonds are not immune to default risk, but the investable universe is dominated by strong companies with an implied investment grade rating. Around two thirds of the convertible market have this high credit quality – either through a direct official rating, or a market implied fair value rating. In our broader, unrestricted strategies, where we can add sub-investment grade convertibles, we are positioned defensively with strong underweights in the worst rating buckets.
The bottom line is that we feel that we can weather a sudden market storm.
Convertibles well placed in a balanced economic and market outlook
Finally, let’s turn a bit more confident for 2020, and look at the positive aspects including the likelihood that a recession is averted, renewed search for yield and the restored risk-on appetite of investors. Overall, while parts of the equity market have come a long way, sentiment remains far from irrational exuberance. Equity holdings seem still a bit light, and opportunities are emerging in convertibles which are trading well below their 2019 highs. The overall market looks under-invested.
Convertibles have delivered for investors over the last 12 months, outperforming equities on a risk adjusted basis (taking into account the amount of volatility) once more. The Sharpe ratios in the chart below show the units of return for every percent of risk in the two asset classes.
Over the long run, a case can be made for convertibles offering attractive returns with lower volatility than equities. We believe that 2020 could just be another year to prove this.
FAQs
Convertible bonds offer the potential for equity-like returns but with lower volatility, combined with the security and capital protection characteristics provided by a bond investment. We believe an allocation to convertibles can enhance your portfolio's risk/reward characteristics.
Why convertible bonds now? ›
Adding convertible bonds to a traditional fixed income portfolio also offers the benefit of exposure to sectors, such as Information Technology and Healthcare, with large weightings in the convertible universe but little or no weight in most fixed income benchmarks.
Who issues convertible bonds? ›
Companies with a low credit rating and high growth potential often issue convertible bonds.
What are foreign currency convertible bonds (UPSC)? ›
A foreign currency convertible bond (FCCB) is a convertible bond that is issued in a foreign currency, which means the principal repayment and periodic coupon payments will be made in a foreign currency. For example, an American listed company that issues a bond in India in rupees has, in effect, issued an FCCB.
What is the difference between a global bond and a US bond? ›
Global bonds are seen as a way to diversify a portfolio that is limited to a specific denomination or one particular country's bond, such as a U.S. bond because this bond will have less correlation to the foreign fixed income bond. Global bonds are grouped into developed country bonds and emerging market bonds.
Are convertible bonds a safe investment? ›
Issuing convertible bonds can also help provide investors with some security in the event of default. A convertible bond protects investors' principal on the downside but allows them to participate in the upside should the underlying company succeed.
What are the disadvantages of convertible bonds? ›
Many of the other disadvantages are similar to the disadvantages of using straight debt in general. To the corporation, convertible bonds entail significantly more risk of bankruptcy than preferred or common stocks. Furthermore, the shorter the maturity, the greater the risk.
What happens to convertible bonds when interest rates rise? ›
There are certain risks associated with an investment in a convertible bond such as default risk—that the company issuing a convertible security may be unable to repay principal and interest—and interest rate risk—that the convertible may decrease in value if interest rates increase.
Why would an investor prefer a convertible bond? ›
Investors are often attracted to convertibles' reduced vulnerability to interest rate moves. The equity characteristics of convertible bonds have made them less susceptible to rising interest rates than non-convertible bonds.
What is another name for a convertible bond? ›
In finance, a convertible bond, convertible note, or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value.
Somewhat different from their counterparts, reverse convertible bonds can be converted into either cash or security during maturity. The issuer holds the conversion rights and can either pay the investor in cash or hand over a set amount of shares per the conversion ratio.
What is the main reason for issuing a convertible bond? ›
Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution. A bond's conversion ratio determines how many shares an investor will get for it. Companies can force conversion of the bonds if the stock price is higher than if the bond were to be redeemed.
What are the benefits of foreign currency convertible bonds? ›
To the Company Issuing Foreign Currency Convertible Bonds:
The coupon rates are usually lower than standard bank interest rates, which minimizes the cost of debt financing. If converted, the company can lower its debt and gain equity capital.
What are the major convertible currencies? ›
A convertible currency is a reliable store of value, meaning an investor will have no trouble buying and selling the currency. Some common fully convertible currencies include the U.S. dollar, Euro, Japanese Yen, and the British pound.
What are convertible bonds also known as? ›
Also known as a convertible note or convertible debenture, a convertible bond is a type of debt instrument that can be converted into another security, usually shares of stock, of the issuing company, usually at some pre-announced ratio based on a fixed number of securities and a set price.
What is a convertible bond in simple terms? ›
Convertible bonds are corporate bonds that can be exchanged for common stock in the issuing company. Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution. A bond's conversion ratio determines how many shares an investor will get for it.
What is a global certificate bond? ›
Also known as a global certificate. A single document representing the entire amount of a particular issue (or tranche) of notes, no matter how many investors beneficially own the notes in that issue. A global note contains basic provisions, such as: The type of security. The total amount.
How does global bond work? ›
A global bond is a bond which is issued in several countries at the same time. It is similar to a Eurobond in that it is denominated in a currency not native to the country that it is issued, but it is also issued in several different countries.
