Convertibles: looking beyond the supply and demand imbalance

Last year the supply of new convertible debt climbed to levels not seen in a decade or more. In the US and Asia, US$84 billion came to the market, which more than outweighed softer levels in Europe.

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supply - demand

At this stage it is hard to know how long this increase in supply will persist for. Driven in the US by a combination of rising interest rates and a change in tax policy that limits the deductibility of interest expense from companies’ tax bills – the net result of the latter being the increased attraction of the (typically) lower coupons available via the convertible market.

A further driver of increased issuance was rising volatility in the stock market. The interest rate a company must pay is to some degree inversely correlated with the volatility of its stock price. Other things being equal, more volatile stock prices enable companies to issue convertibles with lower coupons.

Increased supply has mixed implications for investors. On the one hand, with the value of new issues exceeding the flow of new money into the asset class, the price of existing issues came under downward pressure in the secondary market. However, new bonds tended to be priced competitively to entice sufficient numbers of investors to buy them. That, in turn, offers plenty of profitable investment opportunities.

Looking further ahead, once this supply/demand imbalance has been rectified, the expansion of the number of issues in the market should be viewed positively. It will provide a wider range of investment options and we are already seeing a more diverse range of companies in different sectors, of different sizes and with different credit ratings, issuing convertibles. Further, as the amount of convertible paper outstanding grows new investors are likely to enter the market which should improve liquidity and drive up valuations over the long run.

The normalization of monetary policy occurring globally, albeit at a slow pace, will continue to drive bond yields higher and encourage companies to look at convertibles as a low-cost alternative to conventional debt financing. Over the longer term, we expect demand to be well supported by an increasing recognition of the unique risk/return characteristics convertible bonds offer, along with their broadening diversity.

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Key risks

Convertible securities risk

Convertible bonds can earn less income than comparable debt securities and less growth than comparable equity securities, and carry a high level of risk.

Credit risk

Bond values are affected by changes in interest rates and the bond issuer's creditworthiness. Bonds that offer the potential for a higher income typically have a greater risk of default.

Derivatives risk

The fund uses derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.

Illiquid securities risk

Certain assets held in the fund could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 20 November 2018. Unless stated otherwise any views, opinions and future returns expressed are those of Aviva Investors and based on Aviva Investors internal forecasts. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.  Past performance is not a guide to future returns.

Some of the information within this document is based upon Aviva Investors estimates. It is not to be relied on by anyone else for the purpose of making investment decisions.

Issued by Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St Helens, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. 

In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of  any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration Number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583. In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only.

Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000.

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