Why convertibles deserve a place in strategic allocation

Convertibles combine characteristics of equities and bonds, providing unique opportunities for managing risk and enhancing returns. However, given their distinct nature, investors cannot replicate the characteristics and advantages of convertibles by simply combining a portfolio of equities and bonds.

Furthermore, following a successful 2020, and record issuance we believe convertibles will enter a more prolonged ‘demand’ phase as their value in strategic portfolio allocation for equity, credit and asset allocation investors becomes more widely recognised.

A hybrid structure that’s difficult to replicate

Convertibles uniquely blend the characteristics of equities and bonds. Like equities, convertibles provide upward participation in rising equity markets and are less sensitive to rising interest rates. The convertible’s fixed-income characteristics (the bond floor and coupon income) can help smooth out periods of downside equity volatility. Like bonds, convertibles provide some element of income and less downward participation in declining markets, with less interest rate risk. The price depreciation of convertibles associated with rising interest rates is much smaller than bonds because of their hybrid equity/bond structure.

The conversion feature of convertibles shifts over time the nearer it gets closer to its maturity date, where it is then converted into a fixed number of shares of common stock in the company that has issued the convertible. As it gradually approaches the maturity date, the convertible shifts from being more bond-like to more equity-like. Because convertibles have varying degrees of equity and fixed income sensitivity, they need to be actively managed when the pendulum shifts in markets to ensure they capture market upside and limit participation on the downside – a feature that passive strategies cannot replicate. Furthermore, the hybrid structure of convertibles is enhanced by combining two essential factors: convexity and responsible investing through robust environment, social and governance (ESG) criteria.

 

Did you know: some common terms

Convertible bonds answer to multiple allocation objectives

The hybrid characteristics make convertibles a compelling rationale to be considered as a strategic allocation in order to help pursue a lower-volatility exposure to markets at an overall portfolio level, and well suited to investors looking across equities and fixed income.

Convertibles are not perfectly correlated with either stocks or bonds, their addition to a portfolio as part of a broad asset allocation strategy can help to dampen overall volatility. Convertibles tend to be more highly correlated with equities and high yield bonds, while offering low correlations to investment grade bonds. Furthermore, as convertibles don’t move in perfect unison with stocks and bonds, their addition to a portfolio can create more dispersion of returns.

Convertibles usually exhibit higher Sharpe Ratios than equities, which indicates more favourable risk-adjusted returns, outlined in the chart below.

Index

1 year

1 Year Sharpe Ratio

3 years

3 Year Sharpe Ration

5 years

5 Year Sharpe Ratio

Refinitiv Global Focus Convertible Bond Index USD Hedged

22.84%

1.45

34.75%

0.95

45.11%

0.88

Global Equities: MSCI AC World Index

15.90%

0.43

35.08%

0.44

77.76%

0.69

Global Bonds: BofA Global Broad Market Hedged USD

5.92%

0

16.57%

0.53

24.85%

0.15

Past performance is not indicative or a guarantee of future returns
Source: FE Analytics. All performances in US dollars. Mirabaud Asset Management 31 January 2021.  

 

Equity stabilisers for equity investors

The fixed income aspect of a convertible security tends to provide downside support, while the embedded call option supplies the potential for participation with the common stock’s gains. In the event of a bankruptcy, convertibles rank higher in the capital structure than common stock, as outlined in the chart below.

Furthermore, the bond investment value serves as a theoretical “floor” for the convertible price. The price of a convertible security will normally not rise as rapidly as the common stock in a very bullish market environment, nor will it be quite as defensive as a pure straight bond in a declining stock market environment. Nevertheless, a portfolio of convertibles may exhibit comparable or even superior behaviour to either instrument over complete market cycles.

Reducing credit and interest rate risk for bond investors

Convertibles can be considered for fixed income managers looking to add alpha to their performance or seeking to reduce interest rate sensitivity, especially when inflationary pressures begin emerging. Rising rates typically occur with economic growth and inflation. For bond investors, convertibles can help reduce the impact of rising interest rates due to more potential return coming through the convertible’s equity option. Furthermore, convertible securities tend to be issued with maturities in the range of three to five years, reducing their duration risk versus longer-dated non-convertible and government debt.

The below chart outlines global convertible returns during interest rate rises.

Index

1 Jan 2011 - March 2011

May 2013 – August 2013

September 2016 – December 2016

Global Bonds: BofA Global Broad Market Hedged USD

-0.21%

-2.87%

-2.34%

Refinitiv Global Focus Convertible Bond Index USD Hedged

2.84%

2.49%

1.55%

Past performance is not indicative or a guarantee of future returns
Source: FE Analytics. All performances in US dollars. Mirabaud Asset Management over the time period shown

Lower interest rate risk

The behaviour of convertibles in a rising rate environment

Source: Bank of America and Mirabaud Asset Management, January 2021

The chart above shows that convertible bond performance has historically been positively correlated with climbing rates as equity returns during such episodes have more than offset losses on bond floors. Since 1994, each time when the US 5 year treasury yield rose more than 50bp, convertible returns have reflected positive equity returns in 11 out of 15 times.

The median performance of convertibles and equities were close to +2% while corporate bonds returned -1%. As a result, their inclusion in a balanced portfolio will reduce interest rate sensitivity while also providing the additional benefit exposure to equity upside.

Historically, convertibles have experienced lower levels of default rates compared with high yield bonds. In environments of economic uncertainty, where default rates on high yield are expected to climb, convertible issuers have shown resiliency.

Lower default rate than that of the high yield market in 15 of the past 20 years

Source: Bank of America and Mirabaud Asset Management, December 2020

From a risk management standpoint, one of the compelling features of the convertible market is its low default rate, which has been lower than the high yield market in 15 of the past 20 years, and significantly lower on average. One reason for this is that many convertible issuers have been successful in managing the leverage on their balance sheets, particularly in the tech sector.

A portfolio of convertibles and corporate/government bonds can achieve a higher efficient frontier than a portfolio of equities and corporate/government bonds

A mix of 74% bonds and 26% convertible bonds improves the risk/return of the total portfolio over the period 31/12/2008 to 31/1/2021.

 

To achieve 6% expected return

Corporate & government bonds

Other

Volatility

78%

22% equities

5%

74%

26% convertibles

4.2%

In which, Global equities is MSCI World Index - Hedged Net TR USD; Global Corporate bonds is BofAML Global Investment Grade and High Yield Index; Global Government bonds is BofAML Global Government Index USD and Global Convertible bonds is Refinitiv Global Focus Hedged ($)

Source: Mirabaud Asset Management

For illustration purposes only. This chart is based on simulated data and does not reflect an actual portfolio. Past performance or simulated performance is not indicative or a guarantee of future returns. Indices are not available for direct investment.

A portfolio of global convertible bonds and global corporate and government bonds can achieve a higher efficient frontier than a portfolio of global equities and global corporate and government bonds. As outlined in the cart above, an investor would have needed to take on higher levels of risk to achieve the same return when employing a stock and bond portfolio versus a convertible and bond portfolio.

Record levels of issuance drives more opportunity

Convertible issuance broke through its prior peak and in 2020, it reached an all-time record high – with issuance of $138bn (269 deals), the most since 2007, and up 94% versus $71bn in 2019. Consequently, the global convertible market had climbed to about $488bn at the end of last year, across 1000 issues. Another feature in 2020 is that convertibles became a source of rescue financing from pandemic-hit airline, travel and leisure, and retail industries as it became more challenging to source finance from other methods – such as banking. Technology and healthcare companies also raised capital opportunistically. Even as issuance surged, new issues have generally come at attractive valuations.

We believe this is a defining pivot-point for the convertible market as issuance from traditionally under-represented sectors will draw newer investors into the asset class.

Convertible issuance at record levels in 2020

Source: Bank of America and Mirabaud Asset Management, January 2021

Different composition amplifies diversification

The composition of underlying sectors and issuers in the convertible universe creates strong diversification benefits. For example, the universe reflects a significant weighting in growth sectors across technology and healthcare, which are not normally large corporate bond issuers. Furthermore, the surge in issuance has broadened the sector and name composition, expanding the investible opportunity set, crating strong sector diversification. There is also less issuance from ex-growth sectors such as Banks and the Energy sectors.

Convertibles are issued by large corporations and smaller firms that may not have public debt or long-dated equity options and need a form of financing. As a result of this, convertibles add diversification by providing investors with securities they wouldn’t otherwise be able to replicate with public debt and equity.

Convertible issuers generally look to reinvest at rates close to their required returns on equity, however, they require additional capital. As a result of the hybrid nature of convertible bonds, they can be an attractive financing alternative. This issuer profile is therefore different to many straight bond issuers that might have fewer growth prospects and are adding leverage to increase their returns on equity.

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