Late-cycle equity exposure through convertible bonds
2 minute read
The benefits of exposure to a portfolio of balanced convertible bonds are obvious over nearly any long time horizon. During the later stages of an economic and market cycle, however, the rationale for investing in convertible bonds becomes even more compelling.
Participating in equity returns in strong markets is much of the rationale for owning convertible bonds, and over longer time horizons, global convertibles have actually outperformed global equity on a total return basis. Over the trailing twenty years and ten years, convertibles have returned 110 per cent and 129 per cent of the total return of equities.1
This type of performance is quite reasonable, given that convertibles have largely participated in rising markets – in the five years after the market bottom of the Global Financial Crisis, global convertibles returned 80 per cent of the MSCI World Index return. Meanwhile, convertibles minimized downside participation during market declines, as convertibles shared only 62 per cent of the peak-to-trough decline during the crisis. The market downturn of 2000-02 displayed similar return asymmetry, with convertibles capturing only 52 per cent of the total decline of equities during that period, compared to a nearly 65 per cent participation in the subsequent five years.2
The asymmetrical return profile of balanced convertible bonds lends an important defensive characteristic to the asset class in comparison with traditional equities, while still providing participation to equity gains. The proof of this is in the downside protection that convertibles have historically displayed in declining markets, while maintaining upside participation in rising markets.
For investors adjusting to late-cycle market dynamics, a portfolio of balanced convertible bonds provides a means to maintain exposure to equity markets while mitigating the risks of market declines. The embedded call option feature of the convertible provides for the unlimited upside equity exposure of the underlying in rising markets. Meanwhile, the bond structure of a convertible, along with the short duration nature of the instrument, provides price stability from the bond floor, even in the instance that the underlying equity declines significantly. The impact of any rate rises rate should therefore be muted as interest rates risk is not main driver of returns.
It is the asymmetry in returns on the upside and downside that logically results in longer-term returns capable of meeting or even exceeding that of corresponding equity markets. It is this combination of relative performance which displays the value of convertible bonds as a vehicle for maintaining late-cycle equity exposure.
1 ICE BofAML Global 300 Convertible Index and MSCI World Index
2 ICE BofAML Global 300 Convertible Index and MSCI World Index
Convertible bonds can earn less income than comparable debt securities and less growth than comparable equity securities, and carry a high level of 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.
This fund use derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.
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.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL) as at 11 October 2018. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. 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. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.
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