Demystifying the convertible bond market

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Q Talking to investors and bringing up the idea of convertible bonds, what kind of reaction do you get, and where can you convince them to fit convertibles into their portfolio?

A We often get mystified looks when we speak about convertible bonds to potential investors, but over the years there has been a profound educational process that has brought investors more up to date in terms of the mechanics and the opportunities offered in the convertible market.

Convertibles have a natural fit in either a fixed-income portfolio, where they are potentially interesting as a relative trade versus some other fixed-income products such as corporate bonds, within the investment grade space or the high-yield space, or also in equity portfolios, where they tend to outshine equities in terms of risk-adjusted performance over longer periods of time. For investors who want to dampen volatility in their equity portfolios, it makes sense to add five to 10 per cent of convertible bonds.

Q So they can be all things to all people; to some investors they are a bond, to others they are an equity?

A Absolutely. Products can be either very high-geared and exposed to the equity proportion of the convertible market, or can be tailored to meet investors’ requirements to participate in the equity upside with limited downside.

Q Convertible: a low-yielding corporate debt issue with an attached equity option’. Is that a fair enough description?

A That is a fair definition if you were to consider the basic structure of a convertible bond. In the majority of cases convertible bonds are a senior debt instrument, so they are on equal footing with a lot of straight debt issues of the same company. That is one advantage investors in convertible bonds have relative to equity holders, who are at the bottom of the capital structure of the company.

There is a trade-off when we talk about low yield. Within that bond you’re buying a call option to gain exposure to the underlying equity. That comes at a cost, which is expressed as a lower yield when you compare a convertible bond to an equivalent straight debt.

Q When you hear about outflows from the high-yield market, is that when you are thinking, “Well, this is our time, the money’s going to come into convertibles now”?

A We have seen strong inflows into convertible bonds over the last two and a half years. That has been on the back of, first of all, the great rotation theme, which has not totally materialised, but nevertheless there has been some interest from investors to increase their exposure to hybrid-like structures.

Second, after a very strong few years of returns in the high-yield market, or just generally in the corporate market, some investors might feel tempted to take some profit there, and convertibles offer a decent alternative. The market is limited compared to the high-yield or corporate bond market, but enables investors to play the equity market without having that 100 per cent exposure to the equity story.

Q Cynics might see a convertible bond position as a sign that the asset or wealth manager is showing a lack of conviction, that they’re not prepared to really put their name behind buying a straight bond or an equity, and go all the way. Is this fair?

A  It is not for lack of conviction; it is because of the technical aspects of convertibles, and because of that natural ability to move back into low sensitivity when markets tumble, and to capture the upside when markets rise, that convertibles make sense today to hold in a balanced or fixed-income portfolio.

The convertible bond market is a bit more technical than some other products, so if you’re not an expert in the asset class, picking individual issues would be a little bit more difficult than just picking individual bonds or equities. So it makes more sense to pick a fund or a product that offers that kind of balanced exposure to the asset class.

You can also play the convertible market for all the bells and whistles that are built into the product. We mentioned a bond with an embedded call option, but there are also other factors that drive the valuation of the convertible bond; one of them is the takeover protection that investors can benefit from. In this environment where companies are looking for growth, convertible issuers have many times been targets for larger companies. So a way of playing this M&A theme is by buying into the convertible market.

Q Can you give some examples of popular issues in the market?

A In the US Tesla Motors, has raised north of $1bn (Ä750m) in convertible bonds, so that has been a popular story. In Europe, a lot of peripheral corporates have used the convertible market as a cheap way to refinance as well. Compared to the costs of financing on equivalent straight debt, they shaved off maybe 40-50 per cent of the cost of financing by issuing convertibles. In peripheral markets that have behaved quite strongly, up at least until the beginning of the year, it’s been a nice story to be exposed to some of these convertibles.

We have also seen a few large exchangeable convertibles. These are a little bit different than your standard convertible, but they offer investors the chance to get exposure to a credit – a straight bond, with an embedded equity option to another company. These structures have been quite popular for companies trying to offload cross-holdings they might have across the corporate environment.

Q There are a lot of new managers coming into this space at the moment, but is there a lack of issues of convertibles?

A There has been a growing imbalance between demand and supply, for sure. Nevertheless, new entrants in the market have capitalised on the trend that has appeared on convertible bonds. If we look at the issuance that has materialised over 2013 and, so far, 2014, the prospects are good and I would say there is positive net growth in the convertible bond market. That big imbalance between demand and supply that we saw, particularly in 2012, and up to 2013, has started to soften.

Q Do you have the feeling that we are in a ‘golden period’ at the moment?

A  ‘Golden period’ might not be the appropriate expression, but at this point in the cycle, where investors are concerned about duration risk on fixed-income products, and are maybe looking at positive prospects for equities, it might be a good time to look at convertible bonds, considering also that valuations have dropped because of that softening imbalance between demand and supply.

Q So you’re not subscribing to the theory of impending doom about to swallow us all up, with the financial markets in general about to implode?

A We would like to be a little bit more positive, as we are offering global strategies and therefore we are able to capitalise on different macro trends. As much as there might be more doom and gloom in Europe given the recent macro data and the rising tension across the continent, there is a way to move away from this exposure, and to rather play the US where the macro prospects are more positive, or to play Asia for example, if investors believe the prospects there
are positive because of further QE expectations.

Q Asia went quite cold in 2011 and 2012 in terms of convertibles. How important is the whole raft of Chinese high-tech issues in the US to the revival of Asian convertibles in general?

A It is one aspect of the revival, although convertibles issued by Chinese-listed companies in New York have been mostly classified as US convertibles. But there has also been a lot of local issuance out of Asia, either on the exchangeable side or the tech area; there is a whole space of OEM [original equipment manufacturer] companies that investors can play, for example on the prospects of the new iPhone launches for the next few years.

Real estate is also interesting, as the market is anticipating further stimulus in the property sector. After a tough period for the last two years, the Asian market has now been one of the better performing market of the convertible space in the past two quarters. Although the market is smaller than other regions, we are seeing more interest come into Asia.

Q What kind of signals should investors be looking out for on the horizon before they downgrade any exposure to convertibles?

A First of all, if they believe equities are going to perform better than any other asset class, it does not make sense to be invested in convertibles, unless they want to have a better risk reward, by reducing volatility in the portfolio. Also, it is very important to keep an eye on flows and monitor if investors are adding or pulling money out of the asset class, because that can be a trigger in terms of valuations of the asset class.