We are often asked about the liquidity profile of convertible bonds.
You might be surprised to know that, despite the size of the market at c.USD384bn (as at 1 March 2023), which is roughly 6x smaller than global high yield, convertible bonds are consistently more liquid than high yield bonds and are broadly in line with investment grade bonds, according to Barclays Research.
Because of its size and relative importance in global capital markets, the US convertibles market serves as the best geography to analyse liquidity, especially with the Trade Reporting and Compliance Engine (TRACE), which facilitates the mandatory reporting of over-the-counter transactions in eligible fixed income securities, providing public information on volume.
The average daily traded volume in 2022 decreased to USD1.97bn from USD2.14bn in 2021 and USD2.0bn in 2020, but was still 46% higher than pre-pandemic levels (USD1.35bn in 2019).
The active secondary market is supported by a healthy mix of outright and hedged investors, who are often the marginal providers of liquidity. A typical convertible bond arbitrage strategy employs delta-neutral hedging to exploit a mispricing, in which an arbitrageur buys the convertible bond and sells short the underlying equity at the current delta.
In the years prior to the global financial crisis, convertible bond arbitrage funds controlled about two-thirds of the US market on average. In 2022, they controlled approximately 45%, according to Bank of America Research.
Nevertheless, it is important to highlight that equity profiles (delta >80%), and to a lesser extent, balanced profiles (40%<delta<80%), are more liquid than bond profiles (delta<40%), mainly due to their better hedge ability and broader investor base.
It is easier to deal in names that are constituents of the Refinitiv Global Focus Index, the most widely used benchmark, as it follows selection criteria for liquidity and size of issues. For the US and Europe, the minimum size requirement for entry is USD500mn and EUR375mn respectively. For Asia and Japan, the minimum size requirement is USD275mn and JPY22bn.
What is usually less known is that the index has also rules for price and conversion premium, which explains why the index is active, rebalancing monthly, excluding issues that become too bond-like or too equity-sensitive. The official turnover of the index was 160%, 125% and 132% in 2020, 2021 and 2022 respectively.
Consequently, the index invests primarily in balanced profiles and is usually left with more than 200 issues, compared to a universe of close to 1000 securities. Unsurprisingly, out-of-benchmark names with smaller issue sizes (below USD200mn) are less liquid than larger names, resulting in limited trading ability and/or unfavourable pricing.
In our view, this confirms that you should consider liquidity risk in portfolio construction according to where you stand in the economic cycle, increasing exposure to small and mid-cap, or the credit-sensitive segment, when risk appetite is high and vice versa.
Ultimately, we believe what makes the convertible bond asset class so interesting is its ability to exploit the dispersion between individual issues and not buying the market as a whole.
