Great opportunities in convertible bonds
Before the de-leveraging started in the summer of 2008, convertible arbitrage had been seen as a reliable and very profitable market neutral strategy. The wave of forced selling revealed the leverage needed to make those returns and the fact that arbitrage players owned the majority of the outstanding issues. With no buying by arbitrageurs and no capital available for convertible bond market makers to hold inventory, there were few market bids and prices fell dramatically, leaving the convertible market cheap, dislocated and illiquid - a nightmare for forced sellers, but a rare opportunity for new long-term investors.
In January this year, the average yield of the global convertible universe was in the range 10-15% and 5-10% for investment grade convertibles. Not surprisingly, in addition to renewed marketing efforts by existing long-only convertible fund managers, there have been a number of new long-only convertible funds set up recently. Hong Kong-based Asian fund manager EIP has launched an Asian High Yield Convertible Bond Fund predicated on locking in yields of around 15% net per annum.
The extent of the fall in convertible valuations can be seen in the fact that Asian convertibles currently have a market value of around $35bn versus a nominal value of $61bn, while the EMEA convertible universe has a nominal value of €80bn and a current market value of around €60bn. The result of this is that the convertible investment landscape underwent a seismic shift in valuation methodology as well as actual valuations last year.
IPA asked Jean-Christophe Blanc, Senior Portfolio Manager at CQS why he thinks investors should be taking advantage of the opportunities in the convertible bond space.
“There aren’t many funds specialised in Asian convertibles, although several Asian Funds will have a portion of their assets allocated to convertibles. A fund is probably the best way to invest in convertible bonds. There are a number of considerations for any investor in the choice of a manager, including security selection and the ability to execute trades effectively. Strength of fundamental research is important in order to be able to analyse the strength of the underlying credit. Legal review of all documentation is also critical as convertibles are complex instruments and indentures vary significantly between issuers.
Effective trading capability is a must as the convertibles market can at times be less liquid and bid/ask spreads can be a dampener to investment performance. Also, because of the technical nature of the product, active management is crucial to the accretion of performances. Otherwise, the volatility implied in a portfolio runs the risk of being paid for and not utilized. Should the primary market re-appear, which it most likely will, existing funds should benefit from a new issue allocation standpoint.
The Asian convertibles market is smaller than those in the US and in Europe, and is fairly evenly split between Japan and non-Japan, although the portion of non-Japan has been increasing steadily in recent years. Investment grade or equivalent quality issuance represents about 40% of the market, and has had a tendency of being longer-dated in recent years. There are many bonds which, although not rated, would still be considered to be of investment grade quality due, for example, to the implicit sovereign support offered to the issuer. Over the past few years, a typical investment grade structure would have been a five to seven year maturity, with a put at around year three or four. Lower grade credits are generally shorter-dated. An exception to this rule has been India, where maturities are set at five years by the regulator, irrespective of the issuer. This partly explains why India has been one of the worst performing convertible markets in the downturn.
As hedging instruments are not as widely available in Asia as in other markets, new issuance tends to come at cheaper terms for the investor than in other regions in the world. A large portion of the market will redeem over the next 2 years, and with the lack of recent issuance, the Asian convertibles market is running into a lack of supply, which is one of the reasons explaining the recent positive performance of the asset class.
Up until 2007, leveraged market participants such as investment banks and hedge funds were the primary purchasers of convertibles, but the distribution is now much broader. For example, the recent appearance of crossover buyers (long-only equity and bond funds) and local private banks who are familiar with the product have become an increasingly important part of the investor universe for convertibles, as these instruments have become more common in Asia. The latter used to enter the market via the asset-swap route, but now tend to invest in the bonds directly.
We believe an Asia convertible portfolio is essential part of a global convertible portfolio. Investing only in Asian convertibles will not be representative of the global convertibles market, and such a decision has more to do with the investor disposition towards Asian assets. Valuations and liquidity profiles can also vary significantly between Asia, Europe and the US.
Recent performance has seen a significant contrast between the performance of convertible bonds and other types of bond. Asian convertibles significantly under-performed high yield bonds when the asset class was put under extreme pressure in the third and fourth quarters of 2008. This has now reversed somewhat, as maturity profiles are generally shorter in convertibles than in high yield bonds. Investors have also begun to appreciate that convertibles often carry better corporate action protection features than regular bonds.
The callable nature of the convertibles is a positive in the current market context, as the call would typically be triggered by a corporate action as opposed to a stock rally. The day that investors would have to be concerned by the callable nature of the CBs would mean that equity sensitivity has returned to the convertibles universe, at which point the asset-class should have massively benefited anyway. We believe credit quality is going to be the key driver of performance of the next few years, as Asian companies will not be immune to a likely rise in defaults. However, we believe the massive cheapening of convertibles in the autumn of last year has provided immense opportunity if you have the internal research resource and trading capability. The redistribution that has taken place within the investor community and the significant moderation in the selling pressure coming from leveraged market participants is also very encouraging.