Mirabaud Asset Management’s dedicated convertible bond team talks about delivering an enduring approach to responbsible investing.
The markets are currently facing an unprecedented crisis, an end-of-cycle dynamic marred by high uncertainty, and a corresponding increase in volatility. In such a context, the hybrid structure of convertible bonds, consisting of a bond and a call option, provides the best of both worlds in terms of equities and credit.
The power of convexity and responsible investing
The hybrid structure of convertibles is enhanced by combining two essential factors: convexity and responsible investing through robust environment, social and governance (ESG) criteria. Convexity is an asymmetric behaviour that offers investors protection during market downturns and the potential to maintain their exposure to the equity market with enhanced protection against bear markets. We strongly believe that by selecting convex technical convertible profiles issued by companies with a robust, effective Corporate Social Responsibility (CSR) policy, based around challenges related to sustainability*, we can increase the potential for stronger returns.
We believe that an issuer’s longer-term growth potential is only sustainable if it’s supported by responsible practices. In our experience, companies that are vulnerable from an ESG standpoint are often those facing a high probability of default. Consequently, this places an important emphasis on us to understand the different ESG risks across the convertible bond issuers in which we invest. We begin by excluding companies involved in a range of sectors or that produce products considered controversial. We then leverage areas such as proprietary research to identify a company’s exposure to environment, social and governance risks.
Our focus is to complete a full picture of both the financial and non-financial risks of a company. As a result, demanding ESG analysis focuses our ability to select leading and responsible companies across all sectors and geographical areas. We want to reward and back companies that have a positive impact on the environment and are working hard to avoid non-sustainable activities and governance malpractice. Equally, we are seeking companies that maintain a strong focus on employee welfare and are improving their employees’ working conditions.
Companies at the forefront of good ESG practices help shape a more sustainable world. However, company engagement remains key. Despite the fast-evolving landscape of ESG data collection and assessment, there is still considerable progress to be made in terms of its homogeneity and quality. However, what is in our immediate control is company engagement. In order to understand and sometimes help improve a company’s corporate, social and responsibility practice, we establish robust dialogue with them. Our topics of discussion are varied across areas such as corruption, working conditions in the supply chain, and executive pay. If no constructive dialogue is possible, we may decide to divest from a company that is reluctant to enhance its practice in these areas.
Consequently, responsible investment creates an opportunity to better understand the longer term risks in companies, as opposed to more traditional approaches. Furthermore, we believe that this approach is more robust and more effective in the long term. First, we believe there is a close (and positive) link between a company’s environmental investments and its economic performance, because it optimises the production process as a result of lower consumption of energy and raw materials.
It also makes a positive contribution to the brand. Secondly, a company’s social policy towards its employees has the potential to help improve financial performance, particularly in terms of profitability and productivity. Finally, the concept of governance plays an essential role in a company’s financial results. With good governance comes shareholder confidence and, once secured, it becomes less expensive for companies to raise capital on the market, providing them with more flexibility to manage their growth ambitions.
A defensive approach to equity exposure
In this uncertain climate, convertible bonds with a sustainable focus provide an opportunity to build a defensive exposure to equities to complement existing equity allocations, especially in volatile markets. In combination with our sustainable focus, we also select a limited number of convertible bonds that have convex technical profiles, so we can participate in upside equity markets but with defensive characteristics that come into play in declining markets. We are also highly active in positioning the fund in different market environments by moving from high equity exposure convertible bonds to those that are more bond-like – so we can maintain strong upside/downside characteristics.
On a final note, a number of technical factors have made convertibles more attractive. First, the primary market for convertibles is strong. This means there are many new issuers, which provides an important source of liquidity and opportunity. Secondly, convertibles are currently trading at a discount to their long-term value. This applies to convertibles across all regions, including the US, Europe, Asia and Japan.
* Khan, Mozaffar and Serafeim, George and Yoon, Aaron, Corporate Sustainability: First Evidence on Materiality (9 November 2016). The Accounting Review, Vol. 91, No. 6, pp. 1697-1724. Available at SSRN: https://ssrn.com/abstract=2575912 or http://dx.doi.org/10.2139/ssrn.2575912.