Issuance, support from equities and volatility: The outlook for convertible bonds in 2021

Shawn Mato, convertible bond fund manager, picks three themes that could have a big say in how the asset class performs in 2021.

Issuance, support from equities and volatility: The outlook for convertible bonds in 2021

1. Convertible debt issuance is expected to remain high by historical standards in 2021 following a busy 2020. This should provide a wealth of opportunities, and potentially attract more investors into the asset class.

Convertible bond issuance is on course to grow 50 per cent in 2020 compared with the average of recent years. While new deal activity may fall back slightly in 2021, there is every reason to believe it will remain at a healthy level as an ever-expanding list of companies look to tap into investor demand.

The high level of issuance trend is beginning to spread to Europe and Asia

While the high level of issuance has been driven by US companies this year, this trend is beginning to spread to Europe and Asia. That would be well received by investors, eager to diversify their holdings.

Whereas issuance could be seen as a worrying sign in some markets, such as investment-grade and high-yield corporate debt, the opposite is arguably true of convertibles where the market is still relatively small.

Historically, that has presented a number of drawbacks for investors. For a start, deals tend to be smaller and there are fewer companies in which to invest, making it harder to diversify portfolios. As a result, the market remains a relatively niche area for investors.

Although long-only institutions emain the mainstay of the investor universe, the market’s strong growth is beginning to lure in new buyers, eager to snap up the additional demand.

2. After a dire first quarter, equities recovered over the remainder of 2020. Loose monetary policy and rising economic growth, especially as coronavirus vaccines are rolled out, should continue to support the market in 2021. That would also help convertibles and long-only funds.

Convertibles are a hybrid type of debt instrument that offer investors the ability to participate in rising equity prices. On average, they typically tend to capture around two-thirds of any rise in the underlying share price.

We would expect to see convertibles being pulled higher by underlying equities

As economies begin to open up with the deployment of vaccines, we would expect to see convertibles being pulled higher by underlying equities, with bonds issued by consumer discretionary companies doing particularly well. We also expect bonds issued by technology companies to appreciate. While many tech stocks may be richly valued, the attractions of companies that offer growth potential in an environment where earnings growth will be hard to come by for some time is hard to ignore. New deals by alternative energy companies may also find investor support given this is another area with growth potential.

3. While the outlook for equities is generally positive, a lot of good news has been priced in and economic headwinds remain. If trading conditions remain volatile, this may support convertible arbitrage strategies.

Although economic conditions appear to have improved materially since April, the global recovery remains fragile, particularly if further fiscal stimulus in the US is not forthcoming or if policymakers elsewhere withdraw support too soon.

Equity markets could remain relatively volatile for a sustained period

That could mean equity markets remain relatively volatile for a sustained period. This would be of benefit to investors in convertibles, especially in convertible arbitrage strategies looking to buy bonds that appear cheap relative to the sum of their parts valuation.

In summary

While there has been widespread speculation the nascent economic recovery will cause a reversal of the prolonged period of underperformance by value stocks, investors looking to profit from such a turning point are likely to be disappointed.

The pandemic has highlighted just how challenging the future for many of these companies is going to be; just because their share prices are depressed does not mean they are about to recover. Investors should therefore remain wary of investing in convertibles issued by companies that seem more likely to struggle to grow, even in a healthier economic environment. 

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