The upheaval visited upon global equity markets last month highlighted why an allocation to such bonds makes an ideal ‘halfway house’ for investors anxious to reduce their equity exposure.

Key points

  • Convertibles were a highly efficient home for investor capital in August
  • The decline in convertibles was less than half that experienced by equities in August
  • Despite last month’s market turmoil, the implied volatility for convertibles remained steady
  • This underlines convertibles’ appeal for investors anxious to reduce their equity weightings

One of the unique selling points for convertibles as an asset class has always been that convertible bonds deliver a good proportion of the upside from equity markets – around two thirds – but that they only suffer around half of equity market declines thanks to the ‘bond floor’ they contain. This asymmetry of return helped to make convertibles a highly efficient home for investor capital this summer, especially as the high valuations attached to higher-grade bonds have done nothing to deter investor demand (see Chart 1).

The fundamental appeal of convertibles was demonstrated to good effect in the first 24 days of August when the MSCI World Index declined by 10.45 per cent (in euro terms) on the back of fears of a China-led slowdown in global growth. At the same time, the Thomson Reuters Global Focus Index – a key benchmark for the global convertibles market – declined by just 4.75 per cent.

Part of the explanation for this superior performance lies in the fact that market volatility acts to increase the value of the equity options imbedded in convertibles. As we move further away from the low volatility environment that has been such a feature of markets in recent years, to one of higher realised volatility with far greater dispersion of risk, this naturally helps to sustain the value of convertible options even while equity valuations suffer the directionality of markets. Essentially, while equity valuations decline in an incremental straight line, the decline in the value of an option within a convertible is non-linear meaning that it falls slightly less with each increment. Consequently, if marked on a graph, the line would flatten out as it descends.

The right owners

Despite the turmoil, August provided a good testing ground for convertibles and allowed the fundamentals of the asset class to shine through. This hasn’t always been the case with such violent market gyrations. Back in 2008 in the heat of the financial crisis, the convertibles market didn’t perform nearly so well. Back then, almost 80 per cent of the market was owned by hedge funds which, when the market turned down, became forced sellers.

This time around, with the market mainly in the hands of long-only managers, there was no such technical pressure and implied volatility for convertibles barely moved. This allowed them to remain relatively cheap compared to the fixed-income alternatives, showing them to be an ideal half-way house for investors who might now be reconsidering their equity exposure.

Developing new capabilities

In order to help us build out our existing convertibles capability, the Aviva Investors Convertible Fund Team has put in place a new organisational structure. Following the appointment of Nicolas Schrameck as a Convertibles Fund Manager in April of this year, Stephen Avis joined the Global Convertibles Team as a dedicated execution trader. Stephen started his career at ING Financial Markets as a convertibles analyst. He then went on to work in the hedge fund industry with Basso Capital Management in 2004 and Pine River Capital Management in 2010 as a convertible bond analyst and trader. Over the years, Stephen has managed equity, high yield and convertible bond portfolios.


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