Shawn Mato discusses recent developments in the convertible bond market with Rico Pedrett.
Read this article to understand:
- The opportunities in convertible bonds against a backdrop of elevated market volatility
- Why convertibles have started to exhibit the asymmetric price behaviour traditionally associated with the asset class
- The role convertible bonds can play in a market exposed to persistent inflationary pressures
Convertible bonds have not been immune to the rollercoaster in global financial markets that has characterised 2022. After a strong start to the third quarter for risk assets, investor confidence declined ahead of and during the Jackson Hole central bank conference.
The continuation of hawkish central bank rhetoric in September, alongside Europe’s energy supply concerns and market turmoil following the UK government’s mini-budget announcement, induced strong risk-off moves from which convertible bonds were not spared.
After a phase of stabilisation in July and August, in which convertibles benefited from a valuation tailwind, the severe risk-off environment in the last two weeks of the quarter again put extraordinary downward pressure on valuations.
Yet with most of the convertible market continuing to trade at levels well below par, the asset class is exhibiting historically high yields to maturity coupled with significant equity optionality.
To understand how investors might take advantage of the ongoing market dislocation, Rico Pedrett (RP), multi-asset and macro investment director at Aviva Investors, puts five key questions to Shawn Mato (SM), senior portfolio manager, convertible bonds, Aviva Investors.
RP: Shawn, how would you summarise the performance of convertible bonds in what continues to be a “perfect storm” for most risk assets?
SM: Convertible bonds have been impacted by the recent selloff across markets. Rising interest rates, widening credit spreads and lower equity markets have all weighed on sentiment. However, given that convertibles combine shorter duration credit exposure with equity optionality, the relative performance compared to other asset classes has held up better lately.
The relative performance compared to other asset classes has held up better
This became particularly apparent in the sharp correction leading up to and during the Jackson Hole central bank conference when global equities and global credit retracted more severely than convertible bonds.
Additionally, convertible bonds are particularly exposed to mid-cap growth companies that were amongst the biggest detractors in the equity market dislocation in the first half. Mid-cap and small-cap growth equities ranked among the least-favoured stocks, which exacerbated the technical valuation cheapening in the asset class to some of the most extreme levels we have seen in more than a decade.
RP: Can we draw any parallels in a longer-term context?
SM: Over the last several decades, the market has consistently followed a similar playbook. Any temporary market weakness, such as when we see falling equity markets and widening credit spreads, resulted in a concurrent flight to safety and surging demand for government bonds. What we have seen in 2022, however, is a very different kind of market correction than any we have experienced in the last 30-40 years. Even traditional safe havens aren’t offering any protection.
There were few places to hide in the first half, especially with bond markets falling sharply and interest rates rising across all major economies. As a point of reference, the HFRX Convertible Arbitrage index lost 13.27 per cent in the first half, and convertible arbitrage accounts for a large portion of our absolute-return strategy. Despite this, the asset class has demonstrated in the past that the technical valuation recovery can happen quickly. We believe the case for absolute-return strategies remains compelling.
RP: How do you assess current opportunities in convertible bonds, especially compared to other risk assets?
The asset class is well postioned for the uncertain future
SM: Convertibles have begun to exhibit the asymmetric price behaviour that is a hallmark of the asset class. In our view, this positions the asset class well for an uncertain future as convertible bonds offer an attractive means of gaining equity and credit exposure without taking undue interest rate risk.
Potential upside can still be captured by equity optionality, while convertible structures that sit at or near bond floors can provide protection if downside risk persists.
RP: What about the impact of continued inflationary pressure?
SM: Investors currently face an inflationary environment that we have not seen for 40 years. In this context, convertibles offer significantly lower duration compared to government bonds, investment-grade and high-yield credit.
As the convertible bond universe includes many high-growth, high-potential and high-quality issuers, convertibles could also offer a way to “outgrow” inflation. We have seen this in previous inflationary cycles when convertibles performed relatively well compared to other asset classes.
RP: Finally, what’s your overall outlook for the asset class?
SM: We continue to believe investors with patience and a horizon of more than a couple of months are looking at a potentially compelling proposition.
The asset class offers an attractive way of gaining equity and credit exposure
We expect the current cheapness of the asset class will start to normalise, offering investors an attractive way of gaining equity and credit exposure without taking undue rate risk.