Making the case for convertibles
Making the case for convertibles
Lee Manzi and Makeem Asif discuss the trends in convertible bonds regarding valuations, volatility and issuance.
One of the key benefits of owning convertible bonds that we believe to be particularly relevant in the current market is they offer the potential for improved risk-adjusted returns within a portfolio of stocks and bonds.
A convertible is a corporate debt security that usually pays interest like a conventional bond with the promise of par at maturity but has the additional feature that it can be converted into a set number of the issuer’s common stock at a set “strike’’ price, usually at the discretion of the bondholder.
The option to convert the bond to shares provides upside potential should equity markets rally and the stock price increase. whilst downside support comes from the bond’s coupon payments and principal at maturity.
If we look at the macroeconomic environment, whilst it’s clear that inflation has been much stickier than central bankers and investors had previously thought, the trajectory is lower. The consensus is that interest rates have either peaked or are near peaking across various markets, but the key question is what impact these higher rates will have on the economic environment. We do expect a slowdown to materialise over the coming quarters but believe that anything more than a mild pause in growth will result in the US Federal Reserve and other central banks loosening policy and therefore limiting equity weakness. We saw cracks in US regional banks and in the property space earlier in the year, but these have so far had limited impact on markets This heightened uncertainty is likely to result in higher volatility from what we believe are currently artificially subdued levels, which should benefit convertibles.
Turning to the credit cycle, we think it makes sense to own a portfolio of convertible bonds with an “implied’’ credit rating that is investment grade and that has a low duration in order to have downside support from volatile markets and credit uncertainties. New opportunities are arising for investors as issuance trends have returned to healthy levels after a very weak 2022. Last year, about $40 billion in new issues came to the convertibles market, which in total is about $450 billion and has an average maturity of five years.
That means around $85 billion a year in new issues are needed to sustain the market at current levels, which also happens to be the long-term issuance average. In 2020 and 2021 there were about $160 billion each year. This year through June has seen about $40 billion, so we are around the average run rate.
The convertibles universe also has improved with a broader base of issuers offering higher yields and equity optionality. US utilities are among the recent new issuers, whilst unprofitable technology has taken a back seat from the elevated levels, seen in 2019 and 2020 We also see opportunities in Asia, where we believe the risk profile and valuations to be favourable, and the US is looking more attractive with positive issuance patterns.
A convertible is a corporate debt security that usually pays interest like a conventional bond with the promise of par at maturity but has the additional feature that it can be converted into a set number of the issuer’s common stock at a set “strike’’ price, usually at the discretion of the bondholder.
The option to convert the bond to shares provides upside potential should equity markets rally and the stock price increase. whilst downside support comes from the bond’s coupon payments and principal at maturity.
If we look at the macroeconomic environment, whilst it’s clear that inflation has been much stickier than central bankers and investors had previously thought, the trajectory is lower. The consensus is that interest rates have either peaked or are near peaking across various markets, but the key question is what impact these higher rates will have on the economic environment. We do expect a slowdown to materialise over the coming quarters but believe that anything more than a mild pause in growth will result in the US Federal Reserve and other central banks loosening policy and therefore limiting equity weakness. We saw cracks in US regional banks and in the property space earlier in the year, but these have so far had limited impact on markets This heightened uncertainty is likely to result in higher volatility from what we believe are currently artificially subdued levels, which should benefit convertibles.
Turning to the credit cycle, we think it makes sense to own a portfolio of convertible bonds with an “implied’’ credit rating that is investment grade and that has a low duration in order to have downside support from volatile markets and credit uncertainties. New opportunities are arising for investors as issuance trends have returned to healthy levels after a very weak 2022. Last year, about $40 billion in new issues came to the convertibles market, which in total is about $450 billion and has an average maturity of five years.
That means around $85 billion a year in new issues are needed to sustain the market at current levels, which also happens to be the long-term issuance average. In 2020 and 2021 there were about $160 billion each year. This year through June has seen about $40 billion, so we are around the average run rate.
The convertibles universe also has improved with a broader base of issuers offering higher yields and equity optionality. US utilities are among the recent new issuers, whilst unprofitable technology has taken a back seat from the elevated levels, seen in 2019 and 2020 We also see opportunities in Asia, where we believe the risk profile and valuations to be favourable, and the US is looking more attractive with positive issuance patterns.
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