In the first of a new series, David Clott assesses the key recent developments in the convertible bond market and outlines why this could be an attractive entry point into the asset class with Rico Pedrett.
Read this article to understand:
- How the convertible bond asset class has been impacted by a ‘perfect storm’ of rising interest rates, widening credit spreads and falling equity prices
- The main performance drivers of long-only and absolute return portfolios and strategies
- Why current valuations could offer significant opportunities for patient investors
The global convertible bond market has not been spared from the turmoil that has hit the credit and stock markets this year, given it combines debt and equity features.
Rising rates, widening credit spreads and tumbling stock prices, particularly in small- and mid-cap growth companies, have combined to leave the asset class at its cheapest level since the global financial crisis. Meanwhile, global primary issuance of just $11 billion in the first half was the lowest on record as investors stayed on the side lines.
But with nearly three quarters of convertible bonds trading below par, despite many of them continuing to offer equity optionality, is the asset class set for a turnaround? To find out, Rico Pedrett (RP) multi-asset and macro investment director at Aviva Investors, puts the five key questions to David Clott (DC), senior portfolio manager and head of convertible bonds.
RP: David, what’s behind the sharp correction in the global convertibles market this year?
DC: The correction is the result of several factors. Given their make-up of parts equity and credit exposures, convertibles have not been spared from continued weakness across risk assets. The rise in interest rates, widening credit spreads and collapsing stock prices, particularly for mid- and small-cap growth stocks, have weighed on sentiment. It is not an exaggeration to say a “perfect storm” has caused the asset class to cheapen significantly. This has left convertibles in a place where they offer substantial yields yet still retain significant upside equity optionality.
The convertible bond universe has historically been characterised as a “crossover” credit market. Given elevated volatility across all credit markets, especially with high-yield spreads having recently corrected quite strongly, implied spreads for convertibles remain under pressure. For convertibles with corresponding straight corporate debt, we are seeing a disconnect where these spreads can be wider than straight debt of similar seniority. We expect these aberrations to revert, as they have historically in similar instances.
RP: What is the read across for convertibles from the ongoing uncertainty surrounding interest rates and inflation?
DC: Convertibles offer a defensive profile for investors concerned with duration risk. Relative to sovereign debt, investment grade and high yield credit, convertibles offer significantly lower duration. In our view, the asset class also offers diversification benefits and exposure to a unique set of high-potential, high-quality companies, with most issuers having exclusively convertible bond debt on the balance sheet.
RP: Convertibles have a long history, not only as standalone investments but also for relative-value strategies. What are the main performance drivers of long-only versus absolute-return strategies?
DC: Our experience over the last 20 years suggests changes in the underlying equities are the biggest driver of returns in a balanced convertibles portfolio. Clearly, in a market like we have experienced recently, the negative impact of the equity market correction is accentuated by other factors including interest rates and credit spreads. The extent of weaker valuations become more evident in an absolute-return context. This is especially visible in arbitrage strategies, which are primarily driven by mispricing.
The asset class has demonstrated in the past that the technical valuation recovery can happen quickly
There were few places to hide in the first half, especially with traditional safe haven bond markets widening sharply. As a point of reference, the HFRX Convertible Arbitrage index lost 13.27 per cent in the first half, and convertible arbitrage accounts for approximately 65 per cent of our absolute-return strategy. Despite this, the asset class has demonstrated in the past that the technical valuation recovery can happen quickly, and we believe the case for absolute-return strategies remains compelling.
RP: What about liquidity? Are these losses subject to any potential further mark-to-market impact?
DC: Liquidity has been impacted by recent events, but not to the same extent as other asset classes. Convertibles have continued to trade, albeit with a wider bid/ask spread than in normal market conditions. Having said that, we do not include any illiquid securities in our portfolios, and all positions are marked-to-market daily. Performance therefore doesn’t have any additional time lag due to unrealised losses.
RP: Taking these factors into account, what is your outlook for the asset class?
Patient investors should be rewarded as valuations begin to normalise
DC: Following the correction, nearly three quarters of convertible bonds are trading below par and upwards of 40 per cent below 70. Yields to maturity are mid to high single digits across much of the market, yet many of these securities offer equity optionality and credit exposure without undue interest-rate risk. We believe patient investors should be rewarded as valuations, which have only been cheaper during the Global Financial Crisis, begin to normalise.