Over the past couple of years, investments which gained popularity were Convertible Bonds.
What are convertible bonds?
Convertible bond is a bond which the investor can exchange for a specific amount of company stock at a later date. It basically combines a bond and with a call option. The bond holder can benefit if there is an increase in the stock value and thus exchange the bond into the stock. The amount of stock that a bond holder can acquire is subject to a pre-determined formula.
In other words, Convertible bonds serve a dual purpose – they are structured to thrive in bullish equity markets, whilst retaining the ability to offer value in weaker markets due to their bond like characteristics.
Why do convertible bonds offer value in the current environment?
In 2018, we were introduced to heavy market volatility which generated massive fluctuations in equity markets. Furthermore, US Dollar strength, together with Fed’s rate normalisation continued to weigh on currency markets and also affected almost all maturity segments across the fixed income space, with the exception of those sitting within the lowest duration profiles.
Global convertible bonds enjoy equity like connection through their embedded call option coupled with a short maturity. Below are some reasons as to why there is an increased attention in these instruments:
1) Low Duration
Currently, the Thompson Reuters Qualified Convertible Bond Index has an effective weighted duration (i.e. interest rate sensitivity) of just 3.9 years. This is mostly because the majority of convertible bond issuers prefer to write equity call options which expire in 5 or less years.
Convertibles tend to fall less when Treasury yields rise. As we can see in Figure 2 below, over a period of 15 years where the 10 Year Treasury yield has risen more than 100Bps, the outcome was positive for Global Equities and in turn leading to good returns for convertibles.
2) US government policies helped to decrease issuance of traditional bonds
Policy changes by the US government have been a catalyst for the decrease in issuance of traditional bonds. One change was in relation to interest expense deductibility (IED) regulations, which sets a limit on how much US companies can expense back interest (the maximum is 30% and beyond this companies are susceptible to pay corporation tax).
Furthermore, more lenient rules were introduced to help repatriation of profits held abroad.
High borrowing costs due to rising interest rates, an increased tax burden from reduction of IED, and opportunity to access cash reserves previously held abroad helped to decrease the issuance of traditional bonds.
3) Higher issues of Convertible Bonds
As traditional debt issuance declined, convertible bond issuance increased.
As interest rates increase and hence borrowing costs, it was more profitable for companies to issue these kinds of bonds. As a way of example, if a firm normally requires 6% coupon bond to attract investors, it might be able to get by offering 5% for a convertible bond.
Furthermore, given their higher upside potential, convertible bonds are generally more attractive to investors than traditional bonds.
4) Delta or equity sensitivity
With more issues there has been a decrease in the ‘Delta’ of the Convertible Bonds. With a delta value of 47 (convertible bond index as at Sept 2018), convertible bonds remain attractive versus both equities and bonds.
Delta is the sensitivity of a convertible bond's price to a price change in the underlying asset (shares). For example, a delta of 50% indicates that the convertible bond should rise or fall at half the rate of its underlying shares.
5) Global exposure
Convertible bonds are available across the globe and the index provides around 42% exposure to the US (mainly Tech, Healthcare) and 32% in Europe (majority in the investment grade space).
6) Low default rates
Convertible bonds have experienced lower default rates compared to high yield debt. (see figure 9 below)
7) Risk/Return trade-off
Convertible bonds exhibit equity like performance with only 2/3 of the volatility. Interestingly, as per the below table, over the longer term, these bonds have provided 65% upside and 35% downside participation to global equity performance.
Furthermore, as a result to their risk/return characteristics, convertible bonds provided the best Sharpe Ratio in comparison to both bonds and equities.
8) Small/Medium cap exposure with lower risk.
Overtime, more small/medium cap companies have used convertible debt to tap into the capital markets. The potential upside that is gathered from these traditional growth-oriented companies could present an interesting way to diverse a portfolio with less volatility compared to a pure small/mid cap equity stock.
The convertible bond market has grown in importance especially over the last couple of years due to several factors including the increase in interest rates which has increased cost for new traditional debt issuance and the fact that the wider economy is expected to slow down thus expecting more turmoil to equities.
In my opinion, convertible bonds, as a part of a diversified portfolio, are considered as a way forward in the current environment due to their combination of both equity and bond like features.
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